Committee of Experts report on Regulating audit firms & Networks

The Committee of Experts has submitted its report on Regulating audit firms and the Networks to the Government of India through the Secretary, Ministry of Corporate Affairs. The Committee was constituted on April 20, 2018 pursuant to the directions of the Hon’ble Supreme Court in the matter of S. Sukumar versus The Secretary, Institute of Chartered Accountants of India.  The Committee consisted of Shri Anurag Agarwal, Joint Secretary, Ministry of Corporate Affairs,  Shri Sudhanshu Pandey, Additional Secretary, Department of Commerce and Shri Ravinder, Joint Secretary, Department of Industrial Policy and Promotion.

The report addresses the issues raised by the Supreme Court with a focus to strengthen the legal regime of auditors and promote development of the audit profession in the country. The Committee scrutinised the networking arrangements adopted by the big four audit firms commonly referred as multi-national accounting firms to understand their legal structure and method of operation. The Committee also addressed serious concerns like conflict of interest and transparency arising out of non-audit services provided by auditors and their network, and suggested necessary checks and balances. Further, the report deals with the issue of concentration of market power which is another contemporary problem in the market for audit services.

The global trend indicates a clear shift from self-regulation to independent regulatory structure in the domain of audit regulation due to the failure of self-regulatory model in regulating the professionals. In light of these developments, the Committee found establishment of the National Financial Reporting Authority (NFRA) as a necessary institutional reform which would align the Indian audit landscape with the global position. The Committee also recommended measures to further strengthen the operation of NFRA to address contemporary challenges in relation to auditors, audit firms and networks operating in India.

Since it is important to facilitate a business friendly environment for corporate and professionals in India, Indian laws and regulations on professional services needs to keep pace with changing market dynamics. Taking note of this requirement, the report delves into critical issues like advertising, multi-disciplinary practice firms and branding and suggested measures to rationalise the existing laws. These measures are expected to not only enhance the standards of services offered to corporates, but also facilitate the audit firms to expand in size and operation to compete globally.

For arriving at the findings and recommendations, the Committee adopted a holistic methodology which included internal meetings, engagement with relevant stakeholders, examining past reports discussed in the Supreme Court’s judgment, global literature and best practices in the auditing landscape.

The Committee was ably supported by the research work of the National Institute of Public Finance and Policy.

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Full Text of the Report is as follows:-

Report
October 25, 2018

Constituted by
MINISTRY OF CORPORATE AFFAIRS, GOVERNMENT OF INDIA

COMMITTEE OF EXPERTS ON REGULATING AUDIT
FIRMS AND THE NETWORKS

New Delhi
October 25, 2018

The Secretary
Ministry of Corporate Affairs
Government of India
New Delhi 110001

Dear Sir,

The Committee of Experts to look into the regulating audit firms and the net-works presents its report to the government. The findings and recommendations aim to address the issues raised by the Hon’ble Supreme Court in its judgement in S. Sukumar versus The Secretary, Institute of Chartered Accountants of India (February 23, 2018) with a focus to strengthen the legal regime of auditors and promote development of the audit profession in the country.

Yours sincerely,

Contents

Executive Summary

1. Background

1.1. Methodology followed

1.2. Structure of report

2. Role of auditors and their regulation

2.1. The basic problem

2.2. Auditors resolve agency problems

2.3. Concerns about auditors

2.4. Rationale for regulation

3. Global developments and best practices

3.1. United States of America

3.2. United Kingdom

3.3. China

3.4. Indian developments

3.4.1. Enron fallout: 2002-2009

3.4.2. Post Satyam: 2009-2013

3.4.3. New Companies Act: 2013 – 2018

4. Issues, findings and recommendations

4. 1. Whether India has an appropriate mechanism for oversight of the audit profession?

4.2. What structures are used by networks operating in India?

4.3. Whether Indian network firms are governed or controlled from outside India?

4.4. Whether Indian network firms should be allowed to use the brand name of the network?

4.5. Should Chartered Accountants and firms be allowed to advertise?

4.6. Should auditors, firms and networks be prohibited from providing non-audit services to auditee companies?

4.7. Is the current Indian legal regime of liability of auditors, audit firms and the networks adequate?

4.8. Whether network firms violate section 25 of the Chartered Ac- countants Act, 1949?

4.9. Whether audit firms by being members of international net- works violate the reciprocity requirement under section 29 of the Chartered Accountants Act, 1949? 85

4.10. What measures could be taken to promote multi-disciplinary practice firms?

4.11. How should FEMA and its regulations be enforced on auditors, firms and networks?

Bibliography

Appendices

A. Annexure A – Supreme Court Judgment

B. Annexure B – Government order establishing the Committee of Experts

C. Annexure C – Dates of Committee of Experts Meeting

D. Annexure D – Stakeholders Questionnaire

E. Annexure E – List of Stakeholders

F. Annexure F – Supreme Court extension order

List of Tables

3.1. Important milestones in Indian auditing landscape

4.1. Comparison of prohibited non-audit services

4.3. Chartered Accountants Act 1949

4.4. Companies Act 2013

List of Figures

3.1. Securities Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB)

3.2. United Kingdom: Financial Reporting Council

4.1. Type 1 Network

4.2. Type 2 Network

4.3. Type 3 Network

4.4. Total net capital expenditure as a percentage of annual turnover (ONS, UK Wide) for selected service industries (Source: Legal Services Board)

4.5. The growth in the number of ABS licences (Source: Legal Services Board)

Acknowledgement

I am grateful to members of the Committee of Experts (COE) Mr. Sudhanshu Pandey, Additional Secretary, Ministry of Commerce and Industry, and Mr. Ravinder, Joint Secretary, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry for their sincere and valuable contribution. The task of putting together the key issues, suggesting policy options and developing the rationale for the final recommendations would not have been possible without them.

During the consultation meetings, the COE met several stakeholders comprising audit firms, individual chartered accountants, industry associations, professional institutes and experts from the industry. I am thankful to Mr. Yogesh Sharma and Mr. Rajan Vaidyan from MSKA & Associates, Mr. P. R. Ramesh and Mr. K Sai Ram from Deloitte Haskins & Sells LLP, Mr. Harinderjit Singh and Ms. Sharmila A. Karve from Price WaterHouse Chartered Accountants LLP, Mr. Raj Agarwal and Mr. Sudhir Soni from S.R. Batliboi & Co. LLP, Mr. Kaushal Kishore, Mr. Sanjiv Chaudhary and Mr. Ashish Bansal from BSR & Co. LLP, Ms. Pallavi Dinodia Gupta from S R Dinodia & Co Chartered Accountants, Ms. Abha Seth, Mr. Chandrapal and Mr. Mahesh from Federation of Indian chambers of Commerce and Industry (FICCI), Mr. Marut Sen Gupta and Mr. Vikkas Mohan from Confideration of Indian Industry (CII), Mr. Anil Khaitan from PHD Chambers of Commerce and Industry, Mr. Anil Bhardwaj from Federation of Indian Micro and Small and Medium Enterprises, Mr. Mritunjay Kapur and Mr. Narinder Wadhwa and Mr. Santosh Parashar from Associated Chambers of Commerce and Industry of India (ASSOCHAM), Mr. Deepak Bhalla from Infosys, Mr. Manjeet Bijlani from Edelweiss, Mr. Barindra Sanyal from Tata Consultancy Services, Mr. Sanjay Mathur from Marut Suzuki, Mr. J K Jain, DCM Shriram Limited, Mr. Vinod Jain, Mr. Naresh Chand Maheshwari and Mr. Vaibhav Jain from All India Chartered Accountants Society, Mr. V. Sagar from Institute of Chartered Accountants of India (ICAI), Mr. L. Gurumurthy and Mr. S.L. Gupta and Ms. Indu Sharma from Institute of Cost Accountants of India (ICOAI), Mr. Dinesh C. Arora and Ms. Deepa Khatri from Institute of Company Secretaries of India (IC SI), Mr. Russell Guthrie from International Federation of Accountants (IFAC), Mr. Brian Hunt from International Forum of Independent Audit Regulators (IFIAR). They all have contributed valuable insights which translated into rich input for the COE.

The COE acknowledges the assistance received from Mr. G. Vaidheeswaran, Deputy Secretary and Mr. Rakesh Kumar, Under Secretary at the Ministry of Corporate Affairs (MCA).

The COE was ably supported by the research work of the team at National Institute of Public Finance and Policy (NIPFP) comprising Mr. Pratik Datta, Mr. Sudipto Banerjee, Mr. Shubho Roy, Ms. Shefali Malhotra and Prof. Renuka Sane. I appreciate and acknowledge their contribution to this report.

October 25, 2018

Anurag Agarwal

Acronyms

AAPA American Association of Public Accountants.

ABS Alternative Business Structures.

ADR American Depository Receipt.

AICPA American Institute of Certified Public Accountant.

APESB Accounting Professional and Ethical Standards Board.

ASSUCHAM Associated Chambers of Commerce and Industry of India.

BUD Board of Discipline.

CA Chartered Accountant.

CICPA Chinese Institute of Certified Public Accountants.

CII Confideration of Indian Industry.

CMA Competition and Markets Authority.

CUE Committee of Experts.

CPA Certified Public Accountant.

CSRC Chinese Securities Regulatory Commission.

DC Disciplinary Committee.

DD Director of Discipline.

FASB Financial Accounting Standards Board.

FDI Foreign Direct Investment.

FICCI Federation of Indian chambers of Commerce and Industry.

FRC Financial Reporting Council.

FTC Federal Trade Commission.

IBBI Insolvency and Bankruptcy Board of India.

ICA Italian Competition Authority.

ICAI Institute of Chartered Accountants of India.

ICUAI Institute of Cost Accountants of India.

ICSI Institute of Company Secretaries of India.

IESBA International Ethics Standards Board for Accountants.

IFAC International Federation of Accountants.

IFIAR International Forum of Independent Audit Regulators.

IFRS International Financial Reporting Standards.

IPA Insolvency Professional Agency.

IPO Intial Public Offering.

LLP Limited Liability Partnership.

LSB Legal Services Board.

MAF Multi-national Accounting Firm.

MCA Ministry of Corporate Affairs.

MDP Multi Disciplinary Practice.

MHA Ministry of Home Affairs.

MoU Memorandum of Understanding.

MRA Mutual Recognition Agreement.

NACAAS National Advisory Committee on Accounting and Auditing Standards.

NACAS National Advisory Committee on Accounting Standards.

NFRA National Financial Reporting Authority.

NIPFP National Institute of Public Finance and Policy.

PCAOB Public Company Accounting Oversight Board.

PIE Public Interest Entity.

PW Price Waterhouse.

QRB Quality Review Board.

RBI Reserve Bank of India.

RQB Recognised Qualification Body.

RSB Recognised Supervisory Body.

SEBI Securities and Exchange Board of India.

SEC Securities Exchange Commission.

SILF Society of Indian Law Firms.

SRO Self-Regulatory Organisation.

Executive Summary

Auditors are to resolve agency problems. Moreover, independent audits are fundamental to taking informed and correct investment decisions. Availability of trustworthy financial information on the performance of companies is important to proper functioning of market economy. Serious concerns arise if auditors’ independence is compromised or the trust reposed on them is betrayed.

Determining whether an auditor is independent in fact as well as in appearance is complex. This is especially so because audit firms across jurisdictions often provide services as part of one common ‘network’. Consequently, separate firms belonging to the same network could provide audit as well as non-audit services to the same audit client or its holding company or subsidiaries across the same or different countries. This can give rise to the problem of conflict of interest where independence of the auditor may be compromised. Therefore, measures like sufficient disclosure on total fees, imposing cap on non-audit fees from the audit client, revisiting the scope of prohibited non-audit services are needed to address the issue of conflict of interest, especially at the network level.

These networking arrangements also create an impression that the Indian audit firms which are affiliated with these international networks constitute Multi-national Accounting Firms (MAFs). However, on closer scrutiny it turns out that these Indian audit firms are set up as partnerships or Limited Liability Partnerships (LLPs) under Indian laws and all their partners are members of the ICAI. Therefore, there is neither any violation of section 29 (reciprocity) nor any violation of section 25 (companies not to engage in accountancy) of the Chartered Accountants Act, 1949. Neither can such Indian audit firms be simply be equated to multi-national corporations. Consequently, the term ‘MAF’ is a misnomer.

However, such Indian audit firms admittedly follow various internal processes, policies and methodology adopted by their respective networks internationally. This is aimed at maintaining consistent standards in audit quality globally within a network. While such networks bring better business opportunities in a global economy, they should be subject to necessary checks and balances.

Legal measures need to be supplemented with adequate institutional reforms.

Time and again corporate scandals and accounting frauds have nudged insti-tutional reforms across jurisdictions. One such fundamental reform that has happened globally in the last two decades is a shift away from the Self-Regulatory Organisation (SRO) model towards an independent regulatory structure for the audit profession.

In the aftermath of Enron, the U.S. enacted the Sarbanes Oxley Act, 2002. The Supreme Court in its judgment dated February 23, 2018 has referred to this statute to examine the need of an oversight mechanism for the audit profession. This law inter alia provided for the setting up of the Public Company Accounting Oversight Board (PCAOB) as an independent audit regulator to oversee the audits of public companies. Similarly, U.K., also has a two-tier structure, where the Financial Reporting Council (FRC) is the independent regulator for the audit profession.

In the Indian context, the Satyam incident has been a wake-up call for policy-makers. Pursuant to the global trend of shift from SRO model to an independent regulatory model for audit profession, the Companies Act, 2013 provided for the setting up of the National Financial Reporting Authority (NFRA).

However, the continued opposition to the establishment of NFRA has delayed the implementation of this critical reform. Consequently, although Companies Act, 2013 was enacted in August 2013, the section establishing NFRA was notified only on March 21, 2018 along with the NFRA Chairperson and Members Appointment Rules, 2018. Once NFRA becomes fully operational, it will be adequately equipped to handle the contemporary challenges in relation to auditors, audit firms and networks operating in India.

Finally, it is important to facilitate a business-friendly environment for corpo-rates as well as professionals in India. It is therefore vital that Indian laws and regulations on professional services keep pace with changing market dynamics. Opening up professional services to competition is necessary and therefore, audit firms should be allowed to advertise with some restrictions. Further, in a global economy use of international brand names for audit firms must be allowed. Laws must be rationalised to promote Multi Disciplinary Practices (MDPs) to allow firms to offer a bouquet of high quality professional services at par with international standards. The Advocates Act, 1961 needs to be rationalised to facilitate development of Indian law firms as well as Indian audit firms into MDPs. Adopting these three measures i.e., advertising, branding and MDPs will not only enhance the standards of services offered to corporates, but also facilitate the audit firms to expand in size/operation enabling them to compete internationally.

1 .Background

The Hon’ble Supreme Court of India vide its judgment dated February 23, 2018 in the matter of S. Sukumar v. The Secretary, Institute of Chartered Accountants of India & Ors. (Civil Appeal No. 2422 of 2018) issued the following direction to the Union of India:

The Union of India may constitute a three member Committee of experts to look into the question whether and to what extent the statutory framework to enforce the letter and spirit of Sections 25 and 29 of the CA Act and the statutory Code of Conduct for the CAs requires revisit so as to appropriately discipline and regulate MAFs.The Committee may also consider the need for an appropriate legislation on the pattern of Sarbanes Oxley Act, 2002 and Dodd Frank Wall Street Reform and Consumer Protection Act, 2010 in US or any other appropriate mechanism for oversight of profession of the auditors. Question whether on account of conflict of interest of auditors with consultants, the auditors profession may need an exclusive oversight body may be examined. The Committee may examine the Study Group and the Expert Group Reports referred to above, apart from any other material. It may also consider steps for effective enforcement of the provisions of the FDI policy and the FEMA Regulations referred to above. It may identify the remedial measures which may then be considered by appropriate authorities. The Committee may call for suggestions from all concerned. Such Committee may be constituted within two months. Report of the Committee may be submitted within three months thereafter. The UOI may take further action after due consideration of such report.

The judgment is available at Annexure A. Pursuant to the aforesaid direc-tions, the Ministry of Corporate Affairs, Government of India, set up this Committee of Experts (‘the COE’) vide Office Memorandum dated April 20, 2018 comprising Mr. Anurag Agarwal, Joint Secretary, Ministry of Corporate Affairs (Chairperson); Mr. Sudhanshu Pandey, Additional Secretary, Ministry of Commerce and Industry (Member); and Mr. Ravinder, Joint Secretary, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry (Member). A copy of the aforesaid Office Memorandum is annexed as Annex’ure B.

1.1. Methodology followed

The CUE adopted a holistic methodology including internal meetings, engage-ment with stakeholders, examining past reports discussed in the Supreme Court’s judgment, global literature and best practices in the auditing landscape.

The CUE met nine times including three stakeholder consultation meetings. The dates of these meetings are available at Annex’ure C. During these meetings, the CUE delineated policy issues arising out of the concerns raised by the Hon’ble Supreme Court and deliberated on the same. The deliberations of the CUE were informed by inputs from the stakeholders. The Committee provided a detailed questionnaire (Questionnaire) to stakeholders prior to each consultation meeting. The Questionnaire is available at Annex’ure D.

The CUE adopted the following strategy for stakeholder consultation:

• Meetings with stakeholders: Stakeholders were given an opportunity to give oral submission on the issues mentioned in the Questionnaire through formal presentation which was followed by detailed question and answer session for addressing any further clarification.
• Written s’ubmission: In addition to consultation meetings, stakeholders were also given an opportunity to provide detailed written submission to the Questionnaire within the stipulated time-line.

The CUE consulted relevant stakeholders which included sectoral regulators, audit firms, professional institutes, industry associations and representatives from the industry. The list of stakeholders who engaged with the CUE is available at Annex’ure E.

The CUE gave sufficient time to all relevant stakeholders in providing their inputs to ensure a meaningful consultation process. Since this was a time consuming exercise, the CUE had to seek an extension of another three months from the Supreme Court for submission of the report. The Supreme Court granted the said extension vide order dated July 27, 2018. The extension order is available at Annexure F.

The COE greatly benefited from the thinking of prior committee reports includ-ing the following:

• Report on Corporate Audit and Governance, 2002 (committee headed by Naresh Chandra)
• ICAI, Study Group Report, 2003
• Standing Committee on Finance 21st Report on The Companies Bill, 2009, 2010
• ICAI, Expert Group Report, 2011
• Report of MCA ’s Expert Group on Issues Related to Audit Firms, 2017 (committee headed by Mr. Ashok Chawla)

In addition to these reports, the COE also examined global literature and identified the best practices in the auditing landscape in several jurisdictions like United States, United Kingdom and China.

The deliberations of the COE were also informed by the research conducted by its research secretariat, NIPFP.

1.2. Structure of report

The report is structured as follows: Chapter 2 provides a theoretical framework used by the COE to understand the role of auditors and the rationale for their regulation. It explains the role of auditors in resolving agency problems that are inherent in a corporate structure. The appointment of auditors raises new agency problems, creating various conflicts of interests. Moreover, concentration of market power is also another contemporary issue in the market for audit services. Accordingly, this Chapter argues that regulation of auditors is motivated by these two potential market failures – agency problems and market power – in the market for audit services. It concludes by identifying the broad categories of legal tools that could be used to regulate auditors. Based on this theoretical framework, Chapter 3 analyses the development of the audit profession and corresponding regulations across US, UK and China. In the backdrop of these global developments, this Chapter contextualises the development of Indian auditing market and chronologically explains the evolution of the current Indian legal framework governing auditors. Finally, Chapter 4 delineates the relevant policy issues arising out of the concerns raised by the Hon’ble Supreme Court, provides the opinion of the COE on each of these issues, and gives a rationale that pursuaded the COE to come to that particular opinion on each of the issues.

2.Role of auditors and their regulation

2.1. The basic problem

The efficiency of securities market depends on the availability of trustworthy financial information on the performance of companies. The more quickly new information is gathered, processed, verified and distributed among informed traders, the more efficient is the securities market.¹

A fundamental hurdle in creating an efficient market for corporate securities stems from the agency problems inherent in the corporate structure itself. Such agency problems emanate from three types of information asymmetry. First, due to the separation of ownership and control in the corporate structure, the corporate managers may have more information about the company than its shareholder-owners. Second, the owners of the company who possess majority or controlling interest may have more information than the minority or non-controlling owners. Third, the company may have more information about itself than outside stakeholders with whom it contracts, such as creditors, employees and customers.²

In all the three instances, the agent enjoys informational advantage and may act opportunistically. This is the source of the agency problems. For instance, companies may be tempted to misinform investors in order to inflate the market price at Intial Public Offering (IPO) stage because those in control are selling the securities. This is problematic for investors seeking to rely on the corporate disclosures. Investor’s mistrust may prompt them to discount the value of the company’s shares or even to decline from investing.³ Such agency problems inherent in the corporate structure hamper development of an efficient market in corporate securities.

2.2. Auditors resolve agency problems

Corporate law provides various tools to mitigate these agency problems. One such tool is the trusteeship strategy. This requires a neutral decision-maker to exercise good faith best judgment in making a corporate decision.⁴ Auditors play this role of a neutral decision-maker. They provide an independent check on the work of the agent and information provided by the agent. This helps the principal maintain confidence and trust on the agent.⁵ This reliance placed on auditors to approve financial statements and certain corporate transactions is an example of the trusteeship strategy.⁶

Auditors are also referred to as ‘reputation intermediaries’. The principal trusts the auditor over her own agent as long as the auditor has a clean track record. And the auditor in turn pledges her hard earned reputation, built up over time, to vouch for the agent (the company or its managers). The assumption here is that an auditor being a repeat player in the capital markets has lesser incentive to deceive the principal than the agent. Theoretically, when an auditor has reputational capital whose value exceeds the expected profit from individual client relationship, she should be faithful to the principal.⁷

Auditors often play the critical role of ‘gatekeepers’. The term ‘gatekeeper’ literally means someone that controls access to an activity, in this case the capital markets. For example, a company seeking to access the public capital markets in most countries has to make use of the services of an auditor.⁸ This makes the integrity of auditors all the more important.

Even the legal liability regime on auditors has implications on capital markets. Auditors’ legal liability for an audit failure is an implicit insurance to outside investors. This insurance provided by the auditors enables entrepreneurs to raise capital from investors at lower costs.⁹

Although the concept of auditors orignated to resolve the agency problem within the corporate structure, in a modern economy their role extends beyond this scope. Various primary and subordinate legislation require accounts to be audited for use by stakeholders outside the company itself, like, tax authorities, regulators etc. For instance, under the Income Tax Act, 1961 certain persons carrying out business or profession are required to get their accounts audited. ¹⁰

Therefore, the integrity of auditors is critical for the functioning of various other institutions over and above the securities market.

2.3. Concerns about auditors

Although the primary role of auditors is to resolve agency problems, their appointment leads to a new set of agency problems. These new problems arise because although the auditors are appointed by the shareholders, in practice the management plays a critical role in recommending who should be appointed as auditors.¹¹ The auditors therefore look to the CEOs and CFOs of the auditee company to facilitate continued engagement.¹² Moreover, the auditee company may engage the audit firm for additional non-audit consulting services. The risk of losing fees from a long-term audit engagement and additional non-audit services could align the incentives of the auditors with those of the company’s management, creating new agency problems (commonly referred to as conflict of interest problems).¹³ These conflicts of interest could compromise the independence of auditors, rendering them incapable of resolving the original agency problems discussed earlier.

The provision of both audit and non-audit services raises further complications. Audit firms across jurisdictions often provide services as part of one common ‘network’. A ‘network’ is a larger structure which is aimed at cooperation and is clearly aimed at profit or cost sharing or shares common ownership, control or management, common quality-control policies and procedures, a common business strategy, the use of a common brand-name or a significant part of professional resources.¹⁴ Consequently, separate firms belonging to the same network could provide audit as well as non-audit services to the same audit client or its holding company or subsidiaries across different countries. It is possible that such non-audit services provided by one network firm to a company compromise the independence of another network firm which is providing audit services to the same company or its holding or subsidiary companies.

Once auditors’ independence is compromised, allowing auditors to act as gate-keepers could give rise to a potential moral hazard problem. The existence of a legal mandate to use auditors as gatekeepers may lull other market participants into a false sense of security, causing them to rely on the auditors and seek out less information on their own. Consequently, there may be an expectation gap between what the auditors can actually achieve and what stakeholders think they can achieve.¹⁵

Another serious concern is the lack of competition in the audit profession. ¹⁶ In a concentrated market dominated by a handful of market players, there are risks of implicit collusions. Moreover, in such a market, consumers of audit services may not have the ability to exercise choice effectively. Consequently, reputation risk itself may not be enough to check the behaviour of the dominant audit firms. This concern is further corroborated by instances of reputation-depleting behaviour by some audit firms.¹⁷

2.4. Rationale for regulation

Regulation of a market is not an end in itself. It addresses market failures.¹⁸ Similarly, regulation on the market for audit services should also be targeted to address potential market failures. As is evident from the discussion above, the market for audit services needs to be regulated to address two potential market failures: first, the agency problems emanating due to the inherent nature of the auditors’ role and the resulting moral hazard problems; second, market power

in the hands of few players which raises the possibility of abuse of dominance. These two potential market failures form the primary rationale for regulation of the market for audit services.

Legal regimes across jurisdictions have developed a range of tools to address such market failures. These legal tools could be broadly classified under six categories:¹⁹

1. Qualification and disqualification requirements: The law could lay down specific qualification requirements for acting as a statutory auditor. It could also disqualify persons from acting as auditor of a particular company on grounds of conflict of interest. Such a policy may extend to preventing auditors from providing certain non-audit services to audit clients or requiring mandatory rotation of auditors.

2. Disclosure obligations: The law could impose various disclosure obli-gations on auditors. Such norms could help reveal the conflict of interest that the auditors may face, the sources of funds they receive, and the methodology behind their recommendations.

3. Management of conflict: The law could incorporate rules to mitigate the conflict of interest faced by auditors. For instance, since the board within the company has greatest interest in a lax audit, the law could increase the role of shareholders in relation to audit decisions. Even within the board, it is the executive directors who have the greatest interest in lax audit. Given that shareholders face collective action problems, the law could increase the role of non-executive directors in relation to audit One example of this is the use of audit committees comprising independent non-executive directors.

4. Regulatory oversight: The law could also enhance the regulatory oversight on auditors, making them more accountable to the principal – the shareholders – and other stakeholders of financial statements of the auditee company.

5. Auditors’ power: The law could increase the power that auditors wield against the audited company, thereby making audit decisions more independent. For instance, the law could restrict the maximum fees earned by an auditor from an audit client to ensure that no one audit client is of such substantial material importance to the auditor so as to bias its independence.

6. Liability risk: The law could increase the liability risk of auditors, over and above their reputation risk. This could be achieved by allowing parties who rely on the audited accounts and reports to impose civil liability (damages) on negligent auditors. For instance, the law could increase the litigation risk that auditors could face for negligence. Similarly, criminal liability could be imposed on auditors for false statements in audit reports.

The next chapter applies this theoretical framework to analyse the evolution of the laws and regulations on the market for audit services across some major jurisdictions as well as in India.

3.Global developments and best practices

The early origins of the audit profession can be traced back to medieval Europe.¹ Since then the profession evolved organically out of the competitive dynamics of free markets. But it was the development of limited liability companies in nineteenth century England and America that created a demand for professional accountants and auditors. Prompted by insolvencies and scandals arising out of such limited liability companies,² especially railway companies, the English Companies Act, 1845 for the first time required semi-annual audits of accounts of certain companies by an audit committee composed of shareholders. Although this audit requirement was removed subsequently, the English Companies Act, 1900 reintroduced compulsory audit for limited liability companies.³

The first English professional societies for accountants were set up in 1870. These professional societies established their brand-names by restricting entry of accountants through examinations, establishing standards of conduct, and by adopting the title of ‘chartered accountants’ for their members. The 1880 Charter of Institute of Chartered Accountants in England and Wales listed the accountants’ functions as liquidators, receivers, trustees and auditors, in that order. By 1900, virtually all traded UK companies were audited by professional chartered accountants.⁴

The growth of bankruptcy and liquidation work for accountants that occured

in England during the nineteenth century did not occur in U.S.⁵ As a result, professional societies were established in U.S. later and were influenced by British accounting firms.⁶ For instance, the American Association of Public Accountants (AAPA) – the predecessor of the present American Institute of Certified Public Accountant (AICPA) – was set up in 1887, and the accreditation system began in 1896. By 1920s, most companies listed on New York Stock Exchange were being audited by professional auditors.⁷

It is evident from the above vignettes that the modern audit profession origi-nally evolved organically out of the competitive dynamics of free markets. The early professionals self-regulated themselves to differentiate themselves from lay accountants and to signal their quality and credibility to potential clients.⁸ How-ever, subsequent events prompted increased levels of state interventions, which have largely shaped the current regulatory architecture as well as regulations on the modern audit profession across major economies.

3.1. United States of America

Following the stock market crash of 1929, the Securities and Exchange Act, 1933 for the first time made it mandatory for U.S. publicly listed companies to have independent outside auditors certify the fairness of their financial reports.⁹ Many of the audits that immediately followed were not conducted independently and simply relied on information supplied by the management.¹⁰ This prompted

the AICPA to require auditors to inspect inventories and confirm receivables themselves rather than depend on information from their audit clients.¹¹ Even the Federal Trade Commission (FTC), which initially administered the Securities and Exchange Act, specifically required ‘independent auditors’ not to have any direct or indirect interest in the client.¹² Thus, from early on auditor independence became a critical issue in U.S.

In 1939, the SEC set up a private standard setting body – the Commission on Accounting Procedures, which subsequently became the Financial Accounting Standards Board (FASB) – to establish accounting standards. However, SEC retained the authority to supercede any accounting standard adopted by FASB, if necessary. The accounting profession was left to regulate itself through its professional body, the AICPA. However, state authorities like SEC retained authority to set and enforce standards and discipline those practicing before it.¹³ As per Rule 102(e), the SEC can censure an auditor as well as audit firm or deny it, temporarily or permanently, the privilege of appearing or practicing before it for lack of qualification or unethical conduct.¹⁴

The SEC has always been concerned about the impact of non-audit services on auditor independence. In 1978, it promulgated the Accounting Series Release No. 250 requiring disclosure of non-audit services performed by independent auditors in terms of their percentage relationship to audit fees. It also issued Accounting Series Release No. 264 regarding the scope of non-audit services to enable companies and their auditors to determine whether any proposed management advisory service engagement should be offered or accepted. At that time, the SEC was not keen to prohibit any particular management advisory service. Instead, it expected the accountants to serve as front line guardians of their professional independence. ¹⁵

This self-regulation model had to be reviewed after the WorldCom and Enron scandals in early 2000s. To rebuild investor confidence in the public markets, the Congress enacted the Sarbanes Oxley Act, 2002. It marked the transition from a self-regulatory model to an independent oversight model of auditor supervision. It established PCAOB, a full-time, independent board to conduct

inspections of audits. The PCAOB has five members, who are appointed to staggered five-year terms by the SEC, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, and the Secretary of the Treasury. The PCAOB establishes or adopts standards for auditing, quality control, ethics and independence, taking into account public comments, and subsequently conducts economic analysis of such changes. The PCAOB is further vested with investigation and disciplinary powers. It can also revoke registration and impose monetary penalties on auditors.¹⁶

The Sarbanes Oxley Act, 2002 makes it unlawful for any audit firm, that is not registered with PCAOB, to prepare or issue, or to participate in the preparation or issuance of, any audit report with respect to any issuer, broker, or dealer.¹⁷ The law imposes a legal obligation on PCAOB to conduct a continuing program of inspections to assess the degree of compliance of each registered audit firm with all applicable laws and professional standards in connection with its performance of audits, issuance of audit reports, and related matters involving issuers.¹⁸ Annual inspections are conducted for firms which provide audit reports for more than 100 clients and once every three years for firms providing audit reports for 100 or fewer issuers.¹⁹ The inspection results are published in the public domain if the audit deficiencies are not addressed by auditors within twelve months.²⁰ This acts as a deterrent for audit firms because of the potential reputational damage for them.

The PCAOB also inspects those registered public accounting firms located in foreign jurisdictions that prepares or furnishes an audit report with respect to any issuer. Such inspection is carried out to assess those firms compliance with the Sarbanes Oxley Act, 2002, the rules of the PCAOB, and the SEC.²¹

The Sarbanes Oxley Act, 2002 also strengthened auditor independence by prohibiting auditors from providing certain non-audit services to their publicly traded audit clients.²² It also strengthened the role of the audit committee in public companies by requiring them to pre-approve all audit and non-audit services entrusted by the company to the auditor.²³

The Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010 fur-ther empowered the PCAOB with expanded oversight of brokers and dealers registered with SEC. PCAOB now has registration, inspection, standard-setting, and disciplinary authority over the auditors of broker-dealers. When broker-dealers file their annual reports with the SEC, they are required to include their financial statements and supporting schedules, along with audit reports thereon prepared by PCAOB-registered public accounting firms. Broker-dealers also are required to file compliance or exemption reports, along with examination or review reports that are prepared by the same firms that prepared the audit reports. The audits, examinations, and reviews are required to be performed in accordance with PCAOB standards.²⁴

The regulation of public accounting firms i.e., auditors of listed entities is done both by SEC and PCAOB. However, SEC is the oversight authority of PCAOB.²⁵ SEC has the authority to take action against an auditor for professional misconduct or violating securities laws.²⁶ As explained in Figure 3.1, the investigation is carried out by the Enforcement Division of SEC in-dependent from the Office of Administrative Law Judge which is responsible for disciplinary proceedings and issuing sanctions. Since investigations can be carried out by both SEC and PCAOB, such investigations are duly co-ordinated. Further, PCAOB can refer an ongoing investigation to SEC.²⁷ The regulatory structure provides a clear separation of functions like inspection, investigation and adjudication, which are conducted by different divisions of PCAOB.²⁸

3.2. United Kingdom

In 2002, immediately after the Enron debacle, the UK government undertook a review of the regulatory regime for auditors and accountants and the chal-lenges associated with the SRO regime. The principle recommendation of the review exercise was to enhance the monitoring of the listed entities through an independent audit regulator.²⁹ While FRC existed at that time, but this review exercise lead to its integration. In April 2004, FRC became the UK’s unified independent regulator for corporate reporting and governance.³⁰ Currently, FRC is the competent authority responsible for the public oversight of statutory auditors.³¹ It also assumed the responsibility for issuing accounting standards and dealing with their enforcement.

UK follows a two-tier structure which consists of an independent audit regulator and multiple front-line SROs. The critical regulatory activities concerning the auditors of public interest entities are vested with FRC, whereas some tasks have been delegated to the multiple SROs – Recognised Supervisory Bodies (RSBs) and Recognised Qualification Bodies (RQBs).³² RSBs supervise certain aspects of auditors, whereas RQBs award appropriate audit qualification. These SROs are recognised under the Companies Act, 2006 subject to certain eligibility conditions.³³ These are not statutory bodies and can be de-recognised for breaching obligations.

The FRC has currently appointed four RSBs and five RQBs. Some of these are – Association of Chartered Certified Accountants, Chartered Accountants Ireland, Institute of Chartered Accountants in England and Wales, Institute of Chartered Accountants of Scotland. Each individual RSB is responsible for maintaining its own standards that are overlooked by the FRC. The FRC can also impose financial penalty on RSBs for breaching its obligations and such enforcement measure is published in the public domain.³⁴

The FRC functions through the help of various committees. For instance, it sets the accounting standards through the Code and Standards Committee which takes into account views of stakeholders. Since setting of accounting standards requires expertise, this committee consists of majority of practitioners. On the other hand, the Conduct Committee of FRC, which conducts inspection of audits and regulation of SROs, has a majority of lay members. Further, to ensure objectivity in its function, the Conduct Committee excludes current practising auditors and has no officers of the SROs it regulates.³⁵

As Figure 3.2 shows, if the auditors dispute the findings of the investigation, then an independent disciplinary Tribunal is appointed.³⁶ The Tribunal consists of majority of non-accountants and never has any employee from other division involved in investigation or prosecution. Therefore, the current structure of FRC separates the function of investigation from adjudication to ensure fairness and objectivity. In sum, all the committees in FRC have been composed in a manner to ensure optimum balance between independence and expertise.

The Companies Act, 2006 prohibits a person from acting as an auditor unless such person satisfies the independence requirements in the statute.³⁷ Violation of

the independence requirements by an auditor could invite criminal sanctions.³⁸ The APB Ethical Standard 5 places the task of identifying and managing threats to independence arising out of non-audit work primarily on auditors, but certain types of non-audit services are identified as particularly dangerous and should not be undertaken. These include non-audit services like internal audit, IT design of accounting systems, valuation, acturial services, certain tax services.³⁹

The Companies Act, 2006 also empowers the Secretary of State to issue disclosure regulations to address potential conflict of interest arising out of non-audit services. The Secretary of State has issued regulations for disclosure of terms on which a company’s auditor is appointed, remunerated or performs his duties; the nature of any services provided for a company by the company’s auditor or by his associates; the amount of any remuneration received or receivable by a

Box 1: Sanction on Big Four

In 2017, an independent review was undertaken by a panel chaired by former Justice Sir Christopher Clarke.a The review while discussing sanctions, stated that smaller fines allowed the Big 4 to continue to conduct business by looking at sanctions as the ‘cost of doing business’. While larger fines would discourage smaller firms from conducting larger scale audits and can cause further segregation of the market. The report concluded by suggesting the Big 4 be treated as a separate category when dealing with sanctions. Justice Clarke further recommended an increase in fines to GBP 10 million or more for poor audit work from a Big 4 accounting firm. The FRC accepted the recommendations from the review. It also agreed to make greater use of non-financial penalties like excluding dishonest auditors from the accounting profession for atleast 10 years.

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a Clarke, Chambers, and Long, Independent Review of the Financial Reporting Council’s Enforcement Procedures Sanctions.

The civil liability of an auditor towards the audited entity for a negligent audit is well-established under English law. However, civil liability towards non-client claimants is limited. While in other jurisdictions there has been a move from joint and several liability for auditors to a proportionate liability regime, the Companies Act, 2006 provides for an alternative solution by recognising liability limitation agreements between a client company and its auditor.⁴¹

Additionally, the FRC has introduced its Audit Enforcement Procedure (‘AEP’), which has only been in operation since June 2016. The Sanctions Policy (Audit Enforcement Procedure) supports the AEP. The AEP is concerned with relevant breaches by Statutory Auditors and Statutory Audit Firms. For instance, it would cover a failure to comply with the standards of professional competence, due care and professional scepticism.⁴² As shown in Box 1, the effectiveness of this sanctioning regime on the Big 4 audit firms is questionable.

Concentration in the market for audit services has emerged as a serious concern for contemporary British policymakers. Following the collapse of the construc-tion company Carillion earlier in 2018, the Work and Pensions Committee reviewed the regulations on the audit profession in UK and expressed serious concerns. The Committee noted that in 2016, the Big Four audited 99% of the FTSE 100 and 97% of the FTSE 250 companies.43 In this oligopolistic market, Carillion through its employment of Deloitte (internal auditor), KPMG (external auditor), EY (financial advisor) and PWC (advisor on government contracts) created a situation wherein FRC was forced to appoint the least conflicted out of those firms to review the company’s audits. This allowed PwC to dictate its price thereby turning the oligopoly into a monopoly.

Accordingly, the Committee concluded that waiting for a more competitive market that promotes quality and trust in audits has failed. Instead, it recom-mended referring the statutory audit market to the UK anti-trust regulator, which should consider both breaking up the Big Four into more audit firms, and detaching audit arms from those providing other professional services.44 In October, 2018, the Competition and Markets Authority (CMA) issued a consultation document on the market study it plans to carry out to consider whether the market for the provision of statutory audit is working properly. This study aims to focus on three main issues i.e., improvement of incentives, separation of audit and non-audit services and reducing barrier to entry and expansion of non-big four audit firms.45

3.3. China

In 1949, the People Republic of China was founded, which lead the accountancy profession towards a development course based on the model of socialism. It was only in 1979, when economic reforms started, the existing structure of accountancy profession was revisited. In 1979, the Government promulgated laws on Chinese-foreign equity joint venture which required foreign entities both wholly owned and joint-venture to have their annual financial statements audited by Certified Public Accountants (CPAs). This lead to the growth of new accounting firms which provided services to foreign owned enterprises, because state owned enterprises was not required to be audited.46

In 1981, the Government allowed the entry of accounting firms which were part of the global network. The Big six firms opened their representatives offices in mainland China for liaison and consulting purposes because rules did not permit audit functions.47 In 1985, the Government approved the new accounting regulations for the Chinese and foreign joint ventures which took the accounting profession closer towards the global norms.

In 1988, the Chinese Institute of Certified Public Accountants (CICPA) was established under the supervision of the Ministry of Finance as a SRO.48 In 1992, the Ministry of Finance granted special approval to the Big six firms to form joint venture with the state controlled local accounting firms. This allowed these firms to enter into the domain of auditing, advisory, tax and other professional services in China.49

However, the joint venture structure did not turn out to be much successful for the Big six firms due to interference of the local partner. Therefore, they pushed for allowing the network membership route. In 1996, the Ministry of Finance allowed the international firms to identify members firms in China subject to certain conditions.50

The securities market had a significant impact on the accounting profession in China. The Chinese enterprises raised funds outside mainland China for which they were required to get financial statements prepared in accordance with the international accounting standards.51 In 2001, the Chinese Securities Regulatory Commission (CSRC) issued a regulation which mandated companies seeking listing of shares to get their financial statements audited by international accounting firms.52 The foreign invested enterprises also fuelled growth in the non-audit services which were rendered mostly by the member firms.53

The companies listed on different stock exchanges (Shanghai Stock Exchange, Shenzhen Stock Exchange, Hong Kong Stock Exchange) were required to follow different accounting standards and hence, there was no uniformity. Several developments took place in bringing the Chinese accounting standards at par with the international norms. In 2009, the Ministry of Finance converged the standards with the International Financial Reporting Standards (IFRS).54

Presently, the accounting profession in China is regulated by three authorities i.e., Ministry of Finance, CSRC and CICPA. Firms are licensed by the Ministry of Finance. The firms providing securities related services are jointly licensed by the Ministry of Finance and CSRC. The Ministry of Finance and CSRC also have powers to investigate and take disciplinary actions against auditors of listed entities. CICPA as a professional body, has oversight authority over the firms and the individual CPAs. The accounting standards are set by the Ministry of Finance; whereas CICPA sets the auditing standards but issued by the Ministry of Finance.55

The Law of the People Rep’ublic of China on Certified P’ublic Acco’untants, 1993 states that while CICPA is the national organisation of CPAs, there are local CPA institutes which represent CPAs operating in different provinces.56 Under this law, every CPA is required to join a local CPA institute in respective provinces. These local institutes are responsible for conducting annual examina-tion on professional qualification and annual practice inspection of CPAs.57 The local CPA institutes can revoke the registration of CPAs on grounds of profes-sional misconduct.58 The CICPA can take the following disciplinary measures i.e., reprimand, criticism by circulating notice and public condemnation for non-compliance by its members.59 The finance department of the government at the provincial level or above can issue disciplinary warnings to individual CPA or firm of CPAs for violations and award punishments like, suspending their operations or impose fines.60

Year Developments

2002 High Level Committee on Corporate Audit and Governance

2003 ICAI Study Group Report

2007 Constitution of Quality Review Board (QRB), changes in disciplinary proceedings

2009 Satyam financial fraud CII Task Force on Corporate Governance

2010 Parliamentary Standing Committee on Finance on Companies Bill, 2009

2011 ICAI Study Group Report on operations of MAF

2013 Notification of Companies Act, 2013

2016 Company Law Committee recommends constitution of NFRA

2017 Report of MCA’s Expert Group on Audit Firms

Securities and Exchange Board of India (SEBI) passes order against 2018 Price Waterhouse (PW)

Supreme Court judgment in S.Sukumar v The Secretary, ICAI Cabinet approval on setting up NFRA

Table 3.1.: Important milestones in Indian auditing landscape

3.4. Indian developments

Although the collapse of Enron in 2001 and the demise of Aurther Andersen in 2002 were watershed moments for corporate governance globally, the initial stimulus of corporate governance reforms in India was generated by the Asian financial crisis in 1997-98. Two subsequent events – the Satyam scam and the enactment of the Companies Act, 2013 – further shaped the Indian corporate governance regime. Accordingly, this section will review the development of the Indian regulations on auditors and audit firms across three phases – from the Enron fallout in 2002 to the Satyam scam in 2009, from Satyam scam to the enactment of the Companies Act, 2013 and post the enactment of Companies Act, 2013 till now. Table 3.1 highlights the most critical developments over this period.

3.4.1. Enron fallout: 2002-2009

In the midst of the global churn in corporate governance reforms, the Indian government in 2002 appointed a High Level Committee on Corporate Audit and Governance chaired by Mr. Naresh Chandra to examine various corporate governance issues. This committee undertook a comprehensive examination of various aspects of corporate governance that arose in the context of the Enron failure. Closely on the footsteps of the Report on Corporate Audit and Governance, the ICAI in 2003 issued a Study Group Report which discussed the competition issues in the context of Indian audit firms and firms being members of the international network. In parallel, the Report of the Expert Committee on Company Law headed by Mr. J.J.Irani while suggesting reforms to the company law in 2005, made relevant recommendations pertaining to conflict of interest and liabilities on auditors.

Three major themes of policy reforms emerged from these developments: first, the need to move from the self-regulation model to an independent oversight model for the audit profession like the PCAOB; second, reducing conflict of interest arising out of non-audit services provided by statutory auditors; and third, the competition faced by Indian audit firms from their international counterparts.

First, on the issue of setting up a public oversight body, the Report on Corporate Audit and Governance examined the PCAOB structure. However, it accepted the arguments of ICAI that there was no need for a new regulator and, instead, the existing mechanism needs to be strengthened.⁶¹ As a middle path, it recommended setting up an independent QRB under the Chartered Accountants Act, 1949 to refine the quality of attestation of audits.⁶²

Second, regarding conflict of interest arising out of non-audit services, both Report on Corporate Audit and Governance and Report of the Expert Committee on Company Law stated that there should not be a blanket ban on rendering non-audit services because it could make auditors more dependent on their audit clients for revenue. Instead, prohibition on certain types of non-audit services was recommended, as was the position under section 201 of Sarbanes Oxley Act, 2000. The Report on Corporate Audit and Governance was of the view that audit firms having affiliated and associated entities engaged in non-audit services like consultancy were necessary for better growth and knowledge development. To mitigate the potential conflict of interest issues arising out of such non-audit engagements, it recommended that no more than 25% of the revenues of the consolidated entity should come from a single corporate client with whom there is also an audit engagement.⁶³On the other hand, the Report of the Expert Committee on Company Law highlighted the importance of the liabilities and duties of auditors in mitigating conflict of interest concerns and recommended that these should be put in the law itself instead of rules.⁶⁴

Third, the competition faced by Indian audit firms from their international counterparts was a critical concern for policymakers in this phase. The Report on Corporate Audit and Governance noted that out of approximately 43,000 Indian audit firms, only 0.5% of the firms had more than 10 partners and more than three-fourth of the firms were self-proprietorship concerns. Given such chronically small size, the report was apprehensive that the Indian firms will not be able to compete with international firms in the lucrative consultancy and non-statutory work market. Therefore it was of the view that policymakers should facilitate consolidation of smaller Indian audit firms. It also recommended introduction of limited liability partnership firms to attract more talent to join the profession.⁶⁵ The Study Group Report by ICAI also discussed the competition issues between Indian audit firms and firms part of the international network. It concluded that networking between Indian firms and international firms should be promoted.

The policy deliberations in this phase led to four critical legal reforms from 2005 to 2008. First, the ICAI acted upon the recommendations of its Study Group Report and issued the rules of networking in 2005 allowing Indian firms registered with ICAI to network with MAFs subject to prescribed disclosures given in the rules.⁶⁶

Second, the Chartered Accountants Act, 1949 was amended based on the recommendations of the High Level Committee on Corporate Audit and Governance (Naresh Chandra committee). The newly inserted section 28A of the Chartered Accountants Act, 1949 provided for the setting up of a QRB. Broadly inspired by the PCAOB, the QRB is supposed to review the quality of services provided by the members of ICAI.⁶⁷ The QRB consists of 11 members. The chairperson and five members are nominated by the Central Government and the rest five are nominated by the council of ICAI.

Third, the 2006 amendment to the Chartered Accountants Act, 1949 also stream-lined the disciplinary mechanism within ICAI. Once a complaint is filed before the Director of Discipline (DD), it is required to formulate a prima facie opinion and then place it before the Board of Discipline (BOD) or Disciplinary Com-mittee (DC) depending on the nature of violation. Earlier, the final decision on punishment was taken by the council of ICAI, which is the highest decision making authority. Since the council consists of many members, the meetings were not frequently held which delayed the decision making process. After the amendment, the power to revoke the membership or impose monetary penalty has been vested with the BOD and DC.⁶⁸

Fourth, the Limited Liability Partnership, 2008 was enacted. However, it was only in 2012 that the Chartered Accountants Act, 1949 was amended to allow chartered accountants to incorporate as LLPs, as was originally suggested by the Report on Corporate Audit and Governance.

Evidently, the transformation of the regulatory architecture of the Indian audit profession from a self-regulation model to an independent oversight model began in this phase with the establishment of the QRB. In parallel, reforms were also initiated to facilitate the development of Indian audit firms by formally providing a framework for international networking as well as enabling them to structure as LLPs.

3.4.2. Post Satyam: 2009-2013

The unravelling of the Satyam scandal from December 16, 2008 started ex-posing shortcomings in the extant Indian corporate governance regime. These developments prompted multiple studies of the corporate governance regime in India, that shaped the second phase of policy reforms in this space.

In February 2009, the CII constituted a task force on corporate governance under the chairmanship of Mr. Naresh Chandra. This task force made various recommendations to address the conflict of interests faced by auditors and audit firms. These recommendations fed into the Corporate Governance Voluntary Guidelines, 2009 issued by the MCA. Since the guidelines were voluntary in na-ture, they lacked enforcement capacity. Consequently, the Standing Committee on Finance reviewing the Companies Bill, 2009 recommended incorporating the substantive contents of the Corporate Governance Voluntary Guidelines, 2009 into the bill. The Standing Comittee on Finance also considered suggestions given by various stakeholders for setting up an independent oversight body for auditors and to bring auditing standards within the jurisdiction of company law. In January 2009, the ICAI also set up an expert group to study the functioning of audit firms in India and the different kinds of networks between Indian firms and international audit entities. However, in the absence of sufficient informa-tion, no conclusive position was arrived at. The Expert Group Report issued in 2011 recommended the council of ICAI to further examine the matter.⁶⁹

Evidently, two major themes of policy reforms emerged during this phase, which ultimately influenced the Companies Act, 2013 : first, the need for an independent oversight body for auditors; second, the various legal strategies for addressing auditors’ conflict of interest.

First, section 210A of the Companies Act, 1956 provided for the National Advisory Committee on Accounting Standards (NACAS) which had the mandate to formulate accounting standards for adoption by companies. However, the power of setting auditing standards remained vested with ICAI. The Standing Committee proposed to change this by enhancing the role of NACAS to making recommendations on accounting and auditing standards.⁷⁰ It was also proposed that the name of NACAS be changed to National Advisory Committee on Accounting and Auditing Standards (NACAAS). The standing committee further recommended that NACAAS should also act as as a quasi regulator to monitor the quality of audit undertaken across the corporate sector.⁷¹

Second, on the issue of conflict of interest, Corporate Governance Voluntary Guidelines 2009 recommended mandatory disclosure of network agreements and pecuniary interests between audit firms and their respective non-audit network entities. It also recommended a cap on fees earned by an audit firm and all its associated entities from a single audit client. It further suggested that auditors’ liability should not be limited to the signing partner but must be extended to the audit firm.⁷² The Corporate Governance Voluntary Guidelines, 2009 further recommended the presence of a majority of independent directors in the audit committee and need for certificate of independence by auditors to ensure an arms’ length relationship with the client. It also required the auditor to specifically state the impact of non-receipt of certain information from the management. On its part, the Standing Committee not only endorsed the negative list of non-audit services incorporated in the draft bill but also recommended expanding its scope to subsidiary companies of the audit client.⁷³

Evidently, in this phase, the Satyam debacle prompted rethinking of the regula-tory architecture beyond the QRB under the aegis of ICAI, towards a PCAOB like regulatory body which will monitor the quality of audit undertaken by auditors and audit firms in India. Even the strategies that were proposed for addressing conflict of interest concerns during this phase were more sophisti-cated. For instance, a general consensus seemed to have emerged that conflict of interest could arise at the network level and not merely at the firm level. Further, if non-audit services are provided by the statutory auditors to the parent, subsidiary or any associate entity of the audited company, that could also create conflict of interest. These considerations that emerged during the policy deliberations at this stage, went on to inform the reforms in the next phase.

3.4.3. New Companies Act: 2013 – 2018

Three relevant developments stand out in this phase. The first was the enactment of the Companies Act, 2013. Second, the manifestation of the Satyam episode in this phase revealed critical limitations and ambiguities in the Chartered Accountants Act, 1949. Although some of them have been addressed in the Companies Act, 2013, certain other issues are still contested. Third, this phase

has also seen an active initiative being undertaken by sectoral regulators like Reserve Bank of India (RBI) and SEBI in improving professional accountability of auditors undertaking activities in their respective sectors. These three issues are not necessarily mutually exclusive and therefore, it is relevant to analyse them in detail to appreciate their implications.

First, the Companies Act, 2013 finally provided for establishment of an inde-pendent statutory regulator – the NFRA – for matters relating to accounting and auditing standards.⁷⁴ In line with the powers vested with PCAOB under section 101 of Sarbanes Oxley Act, 2002, the Companies Act, 2013 empowered NFRA to:⁷⁵

1. give recommendations to the Central Government on laying down account-ing and auditing standards;

2. monitor and enforce compliance of standards and oversee the quality of service of the profession and give recommendations;

3. investigate professional misconduct committed by the members of ICAI for prescribed class of body corporate or persons; and

4. issue order imposing monetary penalty as well as debarring an individ-ual member or firm registered with ICAI for 6 months to 10 years, for professional or any other misconduct.

Even after being accorded statutory status, the debate on the need for NFRA continued. In 2016, this issue was considered by the Companies Law Committee, which was constituted to suggest amendments to the Companies Act, 2013. At that time, ICAI had raised objections on the constitution of NFRA. The Companies Law Committee concluded that auditors play a critical role and due to serious lapses in the past, an independent body to oversee the profession was required. It also observed that major economies in the world have already established such regulatory bodies. The Companies Law Committee accordingly recommended that NFRA should be established at the earliest.⁷⁶ Evidently, there is now wide consensus among experts and policymakers about the merit of an independent statutory regulator like NFRA for the Indian audit profession.

Moreover, adoption of NFRA will be in tune with the internationally accepted global best practices in this regard.

The continued debate about the need for NFRA has delayed the implementation of this critical reform. Consequently, although the Companies Act, 2013 was notified in August 2013, the section establishing NFRA was notified only on March 21, 2018 along with the NFRA Chairperson and Members Appointment Rules, 2018.⁷⁷ Currently, the rules on the functioning of NFRA are in draft stage. Once these rules come into effect, NFRA will become fully operational.

The Companies Act, 2013 also addressed the issue of conflict of interest. Inspired by section 201 of the Sarbanes Oxley Act, 2002, section 144 of the Companies Act, 2013 explicitly prohibits provision of eight types of non-audit services by the statutory auditor. Based on the suggestions of previous committees, the prohibition has been extended to the subsidiary or holding company of the audit client. Further, the restriction is also applicable to associate entities of such auditor.⁷⁸ The law has also introduced audit firm liability for violations under the Companies Act, 2013.⁷⁹ Evidently, India has now adopted the current global best practice in this regard too.

In spite of such major strides in legislative reforms through Companies Act, 2013, subsequent events in this phase following the unravelling of the Satyam scandal have led to the second development revealing some limitations and ambiguities in the Chartered Accountants Act, 1949. As is evident from Box 2, the most critical limitation under Chartered Accountants Act, 1949 has been the liability regime on auditors. While monetary liability on an individual auditor is capped at Rs. 5 lakhs, there is no monetary liability on audit firms at all.⁸⁰

However, this loophole will soon be plugged once NFRA becomes fully opera-tional. In case of any professional or other misconduct, NFRA has statutory powers under Companies Act, 2013 to impose monetary penalty up to five times the fees received by an individual auditor or up to ten times of the fees received by an auditor firm. In addition, such individual auditor or the firm could also be debarred from practising for up to ten years by NFRA.⁸¹ Consequently, the limitations in the liability regime under the Chartered Accountants Act, 1949

Box 2: The Satyam case

After the fraud at Satyam Computers Services Ltd. (‘Satyam’) came to light, the PwC partners involved in the incident were stripped of their ICAI membership and were even imprisoned. Even SEBI has passed a disgorgement order of Rs. 3,09,01,664/- against one of the member firms of PwC network as well as the individual audit partners involved under section 11B of the Securities and Exchange Board of India Act.^a However, disgorgement can only take away illegal gains made by the auditor but cannot indemnify investors for a fraudulent or failed audit. Consequently, investors in Satyam’s shares in India were never indemnified for the fraud played on them.

In contrast, since Satyam was listed on New York Stock Exchange, a civil money penalty of $7.5 million was imposed on PwC by the SEC and PCAOB in 2011.^b Additionally, the investors in Satyam’s American Depository Receipts (ADRs) filed a Consolidated Class Action Complaint under Sections 10(b) and 20(a) of the Securities Exchange Act, 1934 against Satyam as well as the auditor PwC firms. The matter finally reached a settlement with Satyam and PwC agreeing to pay the ADR investors $25.5 million.^c

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a. Securities and Exchange Board of India, In respect of Price WaterHouse Co and Others, p. 107.

b. Securities and Exchange Commission, In the Matter of Lovelock & Lewes.

c. United States District Court, In re: Satyam Computer Services Ltd.

could be adequately addressed by NFRA under the Companies Act, 2013.

The Satyam episode also highlighted the role played by international networks, over and above audit firms. Questions were raised about the legality of op-erations of such networks under the Chartered Acco’untants Act, 1949. There were concerns that restrictive conditions imposed by foreign investors tilt in favour of larger audit firms affiliated with these international networks. In this backdrop, the MCA constituted an expert group chaired by Mr. Ashok Chawla in 2016 to look into the regulatory aspects of audit firms. In 2017, the expert group submitted its report which explicitly clarified that the so called MAFs are Indian audit firms with international affiliation but they are controlled and managed by Indian nationals. Further, the report stated that these Indian nationals are members of ICAI and all such network firms have firm registration number issued by ICAI.⁸²

The Report of MCA ’s Expert Gro’up on Iss’ues Related to A’udit Firms observed that ‘merely being part of a network and sharing global costs does not make them MAFs as they are neither owned or controlled by the global parent’. Therefore,

it came to the conclusion that ‘it would not be appropriate to consider the so called MAFs as multinational entities’ since there is no foreign control either through ownership or management and the network partners are run, controlled and managed by Indian nationals.⁸³ In spite of the clarifications in the Report of MCA ’s Expert Group on Issues Related to Audit Firms, questions about the legality of various operations of these networks still exist. This CUE seeks to clarify these issues in detail in the next chapter.

The third major development in this phase has been the initiatives taken by sectoral regulators like RBI and SEBI in improving professional accountability of auditors undertaking activities in their respective sectors. Towards the end of 2017, SEBI issued the Report of the Committee on Corporate Governance where it recommended that there should be adequate disclosure of total fee (audit and non-audit services) earned by the auditor and all entities on the network firms/network entity of which the auditor is a part of.⁸⁴

In early 2018, SEBI penalised PW for its involvement in the Satyam case by prohibiting PW and all its network firms to undertake statutory audit of any listed entity for a period of two years.⁸⁵ Thereafter, in the matter of operation of audit firms who are members of the international network, the Supreme Court delivered its judgment and instructed the Government to constitute a CUE to look into regulatory aspects of such audit firms.⁸⁶

In July 2018, SEBI issued a consultation paper seeking comments on its proposal to amend several regulations related to the role of fiduciary under the securities laws. The proposed definition of fiduciary includes Chartered Accountant (CA) as well as statutory auditor.⁸⁷ In parallel with SEBI, RBI has also racheted up

its supervision on auditors in the banking sector.⁸⁸ In June 2018, RBI issued a graded enforcement action framework to enable appropriate action by the RBI in respect of the banks’s statutory auditors for any lapses observed in conducting a bank’s statutory audit.⁸⁹

In 2018, MCA issued rules on appointment of members of NFRA.⁹⁰. The year 2018 also witnessed the resignation of several statutory auditors of listed entities over a short period of time. MCA has already ordered investigation to ascertain the reasons behind these resignations.⁹¹

Evidently, in this third phase, India has experienced legislative reforms which have upgraded the regulatory structure on auditors and audit firms in tune with the current international best practice. The limitation on the auditor liability regime under the Chartered Accountants Act, 1949 has now been resolved by establishing and empowering NFRA under the new Companies Act, 2013. In parallel, this phase has also seen positive regulatory initiatives across sectors to provide an additional layer of transparency and accountability in the Indian audit profession over and above the statutory scheme under the Companies Act, 2013 and the Chartered Accountants Act, 1949. ilowever, as noted by this CUE, doubts persist as to the application of Chartered Accountants Act, 1949 on networks of audit firms, which will be analysed in the next chapter.

4.Issues, findings and

recommendations

4.1. Whether India has an appropriate mechanism for oversight of the audit profession?

1. The COE is of the view that establishment of NFRA creates no inconsistency between the provisions of the Companies Act, 2013 and the Chartered Accountants Act, 1949.

2. The COE observes that with the recent move towards estab-lishment of NFRA, India has adopted the current global best practice in this regard which can address the problems experi-enced with self-regulation of the audit profession.

3. The COE observes that NFRA has been structured on the lines of international best practices followed by other independent audit regulators in advanced jurisdictions.

4. The COE recommends that NFRA could be further strength-ened and therefore, the rules which are presently being formu-lated, must provide powers to NFRA to publish audit inspec-tion results, subject to necessary checks and balances. This will strengthen NFRA further and will provide an effective tool of deterrence for better compliance by the auditors of public companies with the applicable laws and professional standards.

5. The COE observed that there are benefits of having multiple competiting SROs under one independent regulator like in UK as well as in the new insolvency profession in India. The COE is of the view that a similar model may be considered for the Indian audit profession.

The COE observed that traditionally, professions have been self-regulated. In a self-regulatory model, members of the profession undertake to be a guarantor for competence and conduct of its members.¹ For instance, professions like auditing have been self-regulated where its members established and monitored professional standards, set entry and ongoing education standards and conducted disciplinary actions. Under the self-regulatory model, rules are drafted by the market practitioners/participants using their expert knowledge.² Further, the administrative costs of regulation are borne by the professional members which reduces the regulatory overheads like inspection and enforcement of the government.³

However, the global trend indicates decline in self-regulatory model and shift towards independent regulatory oversight model in the auditing profession. For instance, independent audit oversight regulation exists in countries representing approximately 80% of global stock market capitalisation.⁴ As discussed in Chapter 3, both U.S. and U.K. have moved towards independent regulatory model. For instance, in U.K., FRC is an independent body that regulates auditors of public companies, and has delegated certain tasks related to auditors of private entities to SROs. These powers can be revoked by FRC. FRC can also impose penalty on SROs, if they fail to meet their duties.⁵ U.S. follows a model where SEC along with PCAOB regulates auditor of public companies, whereas professional bodies continue to regulate auditors of the private entities. Under this model, a regulatory body comprising of appointed members (independent of the practitioners) regulate the profession. In other words, unlike in SROs, members are not appointed from the profession through an electoral process. As shown in box 3, this feature of independent regulatory oversight of audit regulators has been internationally recognised.

There are numerous reasons behind this shift towards independent oversight like, financial frauds, trust deficit arising out of auditor’s failure to act as gate-keepers and lack of accountability. For instance, after the Enron and WorldCom frauds in U.S., several jurisdictions gradually shifted towards an independent regulator for auditors. Further, the globalisation of economy fuelled demand for standardisation of financial reporting to protect the interest of global investors.⁶

Box 3: Features of independent regulatory oversight

• IFIAR, which is a forum of 52 independent audit regulators, has developed certain core principles based on the experience drawn from independent audit regulators in different It requires that the legal framework should provide the regulator with adequate powers and authority that enable the regulator to perform its audit oversight duties. For instance, it should have powers of inspection and investigation to enforce compliance with professional standards and powers to impose sanctions. Further, it requires that the audit regulator should be operationally independent from the audit practitioners. ^a
• Further, the European Parliament has laid down certain principles for constituting a public oversight body to regulate the auditing profession. It states that such body should have the ultimate responsibility of approval and registration of standards, licensing and registration of statutory auditors as well as for standard setting on ethics and auditing, quality assurance and disciplinary systems.^b

____________________________

a. See, Principle 1 and 2, International Forum of Independent Audit Regulators, Core Principles for Independent Audit Regulators, p. 3.

b. Article 32, European Parliament and the Council, Directive on Statutory audits of annual accounts.

This trend pushed countries towards a similar regulatory approach in the form of independent regulatory structure.⁷

Further, over the years, several drawbacks with the SRO model have emerged. SROs may claim that their interests are in line with public interest but in practice, it may be otherwise.⁸ It has been observed that when professional bodies are required to self-regulate auditing professions, they are placed in a seemingly contradictory situation. On one hand, they have to regulate and discipline members of the same profession to safeguard the public interest, and at the same time promote their profession to compete with other professions.⁹

Further, if any action is taken against the members, it may not be commensurate with the wrongdoing. ¹⁰

Box 4: Prime Minister’s speech on ICAI’s foundation day

In 2017, the Prime Minister, speaking to the chartered accountants on the foundation day of the ICAI, expressed concern over the efficacy of ICAI’s disciplinary mechanism. He had said:^a

…..CA is an arrangement in which Human Resource Development (HR) is done only by you. Curriculum is made by you only; you conduct the exam; Rules and Regulations are also made by you, and your institute only punishes the culprits. Now the question arises that the temple of democracy i.e. the Parliament of India, which is the voice of 125 crore countrymen, has given you so much authority, then why is it that in the last 11 years, only 25 Charted Accountants have been prosecuted. Did only 25 people make a mess? And I have heard that more than 1400 cases are still pending for many years now. A single case takes years to settle

______________________

a. See, Modi, PM’s speech at Chartered Accountants ’Day at IGI Stadium, Delhi

Indian development: National Financial Reporting Authority (NFRA)

The COE noted from Chapter 3 that the rethinking of corporate governance in India began in the aftermath of the Asian financial crisis in 1997-98. Subse-quently, the Enron scandal triggered the debate on the need for an independent audit regulator. In 2002, the Naresh Chandra Commmittee had reviewed the necessity of having India’s own public accounting oversight board similar to PCAOB in U.S., but it did not recommend its establishment keeping in view that setting up such body would have required consolidation of powers vested with different regulators.¹¹ In 2010, the Standing Committee on Finance recom-mended that NACAS should be given mandate to regulate auditing standards, which was then under the jurisdiction of ICAI. The committee also recom-mended that NACAS should be vested with powers to regulate the quality of audit undertaken in India.¹² Again in 2016, the Company Law Committee strongly recommended creation of an independent oversight mechanism in the auditing profession.¹³

Keeping in view the past recommendations of various government committees

and the global developments, the Companies Act 2013 brought in NFRA, an independent regulatory body to regulate the profession of auditors. As noted in Chapter 3, Section 132 of the Companies Act 2013 vests NFRA with several powers. The present legal framework also empowers NFRA to take action not only against an individual CA, but also against a firm of CAs. The COE is of the view that this power is essential to create sufficient deterrence at the audit firm level and is expected to address one of the most critical limitation under the Chartered Accountants Act, 1949. Further, Section 132 provides for an appellate tribunal to address grievances arising out any order passed by NFRA. Therefore, the COE notes that the current legal framework provides for an effective independent regulatory mechanism for auditors which was needed considering the serious lapses in the past and their repercussions.

Although the Companies Act, 2013 was notified in August 2013, the section establishing NFRA was notified only on March 21, 2018 along with the NFRA Chairperson and Members Appointment Rules.¹⁴ The continued debate about the need for NFRA delayed the implementation of this critical reform. Presently, the rules regarding the functioning of NFRA are in draft stage. Once these rules come into effect, NFRA will become fully operational.

Consistency between legislations

The COE has noted that creation of independent regulatory oversight through NFRA is in addition to the existing tier of SRO and does not contradict the Chartered Accountants Act, 1949. From the information available in the public domain, the COE noted that under the framework of Companies Act, 2013, NFRA would regulate auditors of only listed companies, and public compa-nies beyond a certain threshold. On the other hand, ICAI as SRO under the Chartered Accountants Act, 1949 would continue to regulate the auditors of public companies below a certain threshold and private companies.¹⁵ Further, the Companies Act, 2013 regulates the auditors of a company appointed for the limited purpose of statutory audit, on the other hand, the Chartered Accoun-tants Act, 1949 is a legislation which governs the overall chartered accountancy profession. Also, the powers vested with NFRA under the Companies Act, 2013 would not exclude the jurisdiction of ICAI under the Chartered Accountants Act, 1949, unless when NFRA initiates an investigation into matters of profes-sional misconduct of auditors of only listed companies and public companies beyond a certain threshold.¹⁶ The COE also considered the findings of Standing Committee on Finance 21st Report on The Companies Bill, 2009 which strongly recommended the need for an independent body to monitor the quality of audit undertaken across the corporate sector.¹⁷

The COE also noted other sectoral developments in the domain of regulating auditors which have been discussed in Chapter 3. For instance, the RBI has issued an enforcement action framework for actions to be taken by RBI against the statutory auditors of banks for lapses observed in conducting a banks statutory audit.¹⁸ Similarly, SEBI is considering amendments to several regulations to include CAs as well as statutory auditor within the scope of fiduciary to initiate necessary actions against them for breaching the securities laws.¹⁹ This growing inclination of other regulators to initiate action against auditors in the event of lapses, could be an indication of challenges in the current SRO structure of ICAI.

Further, the COE studied the international experience which suggests that, regulators like PCAOB and FRC already follow the two-tier structure which consists of both independent audit regulator and SRO. For instance, in U.S., the SEC and PCAOB regulates auditors of public companies registered with SEC, whereas AICPAs is a SRO for the accounting profession. Similarly, in U.K., the FRC is the independent regulator for the audit profession and there are four RSBs under it, which function as SROs. Further, the global literature also states that in this model, the threat of enforcement by the independent audit regulator may lead to more enforcement by the SRO and thereby improve its regulatory efforts.²⁰

For the reasons discussed above, the COE is of the view that establishment of NFRA is an insightful regulatory development and it creates no inconsistency between the provisions of the Companies Act, 2013 and Chartered Accountants Act, 1949. The COE believes that creation of NFRA would have dual benefits.

First, NFRA would align the Indian regulatory architecture in the auditing landscape with the global trend; and second, it is expected to address the problems associated with the current SRO mechanism under ICAI.

Strengthening of NFRA

The COE observed that globally there has been a growing acceptance of independent audit regulators, because they are expected to restore investor’s confidence and bring more transparency and accountability in the auditing profession.²¹ In light of this, creation of NFRA is a positive development. While NFRA as an audit regulator has been vested with necessary powers, drawing inferences from global best practices may help in creating a more robust regulator.

The COE noted that independent audit regulators in other jurisdictions have been empowered to publish the results of audit inspection. For instance, the Sarbanes Oxley Act, 2002 authorises PCAOB to inspect registered firms and publish the results. Further, if such inspection reveals any deficiency or defect which are not remedied within 12 months by the audit firm to the satisfaction of PCAOB, it can publish that portion of the inspection report which deals with criticism and defects.²² The public copy is redacted accordingly to protect the confidential and proprietary information of the inspected firms.²³ Other audit regulators like FRC in UK also publishes individual reports of their audit quality inspections of each major audit firms.²⁴ Such publication is subject to necessary confidentiality obligations.²⁵

Empowering NFRA on similar lines can have dual benefits. First, reputation is a critical capital for audit firms to generate business.²⁶ Fear of loss of reputation can be an effective deterrence for firms to build better internal checks and balances. Second, investors in the capital market can be expected to make more informed choices if they are supplied better quality of information about the performance of auditors of listed entities. Section 132 of the Companies Act, 2013 already vests NFRA with the powers to monitor/inspect the quality of services provided by auditors to ensure compliance with the standards. Therefore, the NFRA rules which are being drafted must include the power to publish inspection results.

Multiple SRO model

The COE also noted that creating an ecosystem of multiple SROs can gener-ate competition among them which is necessary for the development of any profession. The COE studied the UK jurisdiction which follows a multiple SRO structure in the audit profession in the form of RSBs and RQBs.²⁷ Un-like ICAI in India, RSBs and RQBs are multiple competing SROs. Further, these are not statutory bodies and given recognition under the Companies Act, 2006 after complying with certain eligibility conditions.²⁸ They can also be de-recognised, if they fail to continue to meet those conditions.²⁹ The FRC as an independent regulator delegates certain tasks to these RSBs through delegation agreement.³⁰ Further, the FRC can impose financial penalty on RSBs for breaching its obligations and such enforcement measure is also published in the public domain.³¹

In the Indian context, instance of multiple SROs can be found in the insol-vency profession. The Insolvency and Bankruptcy Code, 2016 provides for multiple Insolvency Professional Agencies (IPAs) which regulates the insolvency professionals under SRO model through its bye-laws.³² The Insolvency and Bankruptcy Board of India (IBBI), an independent statutory regulator, has the power to give certificate of recognition to these IPAs which can be suspended or cancelled on breaching its obligations.³³ Presently, there are three IPAs in India and one them is ICAI itself. The Bankruptcy Law Reforms Committee noted that there is a need to create a new model of self-regulation which is unlike the current structure of professional agencies having a legal monopoly over their respective domains. The rationale behind creating multiple SROs is to ensure healthy development of the profession of insolvency practitioners through efficient regulatory efforts.³⁴

In light of these developments both in the domestic and international landscape of professions, the COE notes that first, it is not necessary to have a single statutory SRO. Second, there are benefits of having a multiple competing SRO structure which may result in healthy development of the audit profession.

4.2. What structures are used by networks operating in India?

The COE is of the view that there are three types of structures used by networks operating in India:

1. Type 1 Network: This category consists of domestic networks which could be formed by CA firms set up by CAs registered with ICAI..

2. Type 2 Network: This category consists of international net-works where domestic CA firms set up by CAs registered with ICAI network with entities outside India using the membership

3. Type 3 Network: This category consists of international net-works where domestic CA firms set up by CAs registered with ICAI network with entities outside India using the sub-licensing route.

The COE examined the legal structure of the big four global accounting ‘net-works’.³⁵ Each such network includes a global umbrella organisation. Three of these – Ernst & Young Global Limited, PricewaterhouseCoopers International Limited and Deloitte Touche Tohmatsu Limited – are U.K. companies limited by guarantee.³⁶ The fourth, KPMG International Cooperative, is a coopera-tive under Swiss law.³⁷ These umbrella entities themselves do not provide any client services. Instead, they serve as coordinating entities for a network of independent firms, each of which provides services in a particular jurisdiction subject to the respective local laws.³⁸ Some networks have interposed additional coordinating organisations between the global entity and the individual affiliates that provide client services.³⁹

In India, under section 141(1) of the Companies Act, 2013, a statutory auditor could be a CA or an audit firm, with majority of partners who are CAs, set up as a partnership firm under the Indian Partnership Act, 1932 or the Limited Liability Partnership Act, 2008. Initially, audit firms operated in India with international brand names like Price Waterhouse, Lovelock and Lewess, A.F.Ferguson and Co., Fraser & Ross and Deloitte Haskins and Sells. Some of these audit firms came into existence in the pre-independence era and were already part of the respective international networks. In 1988, ICAI issued new regulations which required new firms to apply to the ICAI for approval to use a firm name.⁴⁰ While the audit firms with international brand names operating in India prior to 1988 were protected, no new firm name reflecting the brand of the international network were allowed.⁴¹ Consequently, the networking route took off in India. Subsequently, the ICAI issued the Rules of Network, 2005, which was superceded by the Revised Guidelines of Network, 2011, to regulate networks operating in India.

The COE reviewed relevant contracts submitted by SRBC and Co. LLP, Deloitte Haskins & Sells LLP, Price Waterhouse Chartered Accountants LLP, BSR and Co. LLP and MSKA & Associates. Based on a review of these documents, the COE concluded that there are broadly three types of networks operating in India:

1. Type 1 Network: A domestic network could be formed by CA firms set up by CAs registered with ICAI (see Figure 4.1). The name of such a network must be approved by ICAI. Within 3 months of such approval, the network must be registered with ICAI.⁴²

2. Type 2 Network: Domestic CA firms set up by CAs registered with ICAI could also network with entities outside India using the membership

route.⁴³ In this case, a foreign entity (the international network) enters into a membership arrangement with the domestic CA firm which operates under its local trade name (see Figure 4.2). This is based on contractual agreements (joining/membership agreements) executed between the for-eign entity and the domestic CA firm. Unlike Type 1 networks, there is no registration requirment for Type 2 networks in India. A duly authorised representative of the Indian member firm is required to file a declaration with ICAI under Form D within 30 days of entering into the network arrangement.⁴⁴

3. Type 3 Network: Domestic CA firms set up by CAs registered with ICAI could also network with entities outside India using the sub-licensing route.⁴⁵ In this case, the domestic CA firm does not enter into direct mem-bership arrangement with the international entity. Instead, it enters into a sub-licensing agreement with an Indian entity, which is a member firm of that international network (see Figure 4.3). This sub-licensing agreement allows the domestic firm to use the brand name(s) of the international network without entering into any direct contractual relationship with the international entity itself. Moreover, the domestic firm follows the same global procedures and methodologies prescribed by that international network by virtue of the sub-licensing agreement and other contractual arrangements. Therefore, the legal structure used by Type 3 networks is aimed at co-operation and is clearly aimed at common quality control policies and procedures or use of a common brand name, which squarely falls within the definition of ‘network’ under the Revised Guidelines of Network, 2011. Consequently, there is a legal obligation on the domestic network firm to make appropriate declaration with ICAI.⁴⁶

4.3. Whether Indian network firms are governed or controlled from outside India?

The COE concludes that the term MAF is a misnomer. The COE agrees with the observation in the Report of MCA ’s Expert Group on Issues Related to Audit Firms, which had noted that merely being part of a network and sharing of global costs do not make these In-dian network firms MAFs as they are neither owned nor controlled by the international network/entity. These are Indian firms regis-tered with ICAI with partners who are members of the ICAI.

The CUE observed that there is an impression that Indian audit firms which are affiliated with these networks may be governed or controlled from outside India.⁴⁷ The CUE examined if this perception is correct.

The CUE noted that ICAI has permitted networking through the Revised Guidelines of Network issued in 2011. The term ‘network’ has been defined by ICAI to mean a larger structure clearly aimed at common quality control policies and procedures, common business strategy etc.⁴⁸ Some of the stakehold-ers have highlighted to the CUE that membership of an international network helps them adopt consistent audit methodology globally, common technology, infrastructure, IT tools, quality, risk management and conflict of interest prac-tices.⁴⁹ It is therefore natural that there will be some policies and procedures adopted by the network internationally related to the supervision and control of internal processes followed by the member firms globally including those in India. Therefore, such supervision and control of internal processes of an Indian chartered accountant firm by the network is a sine qua non of networking as defined under the Revised Guidelines of Network.

The COE noted that s’upervision and control of internal processes of network firms is aimed at maintaining consistent standards in audit quality globally within a network. This helps ensure a certain consistency in the level of services offered to clients by the network firms globally. Such s’upervision and control over internal processes for consistent audit quality cannot be equated with ownership or control for the purposes of corporate law. Instead, such s’upervision and control of internal processes by a network helps improve service quality to consumers.

Therefore, the COE concludes that the term MAF is a misnomer. The COE agrees with the observation in the Report of MCA ’s Expert Gro’up on Iss’ues Related to A’udit Firms, which had noted that merely being part of a network and sharing of global costs do not make these Indian network firms MAFs as they are neither owned nor controlled by the global parent.⁵⁰ These are Indian firms registered with ICAI with partners who are members of the ICAI.

However, the COE also felt that since international network entities bring better business opportunities in the days of global economy and have ability to invest hugely in technology to improve processes & standards, they may wield influence on the Indian audit firms which are part of the network.

4.4. Whether Indian network firms should be allowed to use the brand name of the network?

1. The COE is of the view that branding with international net-works would increase competitiveness of the Indian audit firms. Further, Indian companies may benefit from using Indian au-dit firms which are members of international networks with a brand name.

2. To further facilitate this, the COE recommends that NFRA and ICAI should make appropriate changes to respective laws and regulations, including Regulation 190 of Chartered Accountants Regulations, 1988 and Code of Ethics, 2009.

Regulation 190 of Chartered Accountants Regulations, 1988 require a CA firm established in India after 1988 to apply to the ICAI for approval to use a firm name.⁵¹ Subsequently, since 2005, ICAI has allowed Indian CA firms to enter into contractual or other arrangements with an international network and become members of the said network.⁵² This Revised Guidelines of Network, 2011 allows use of a common brand name.⁵³ Consequently, the Indian network firms providing audit services are often associated with the brand name of the network.

The COE noted here that Regulation 190 does not explicitly prohibit usage of international brand names of networks. It merely restricts the trade/firm name to name of the proprietor or partner(s) of the firm. It also provides several options for using the names, like full surname, full first name, combination of the first name, middle name, initials of full name, etc. The regulation gives power to the council of ICAI to reject a trade/firm name which smack of publicity. Further, the council of ICAI reserves the discretion to refuse registration of a trade/firm name, if that name is undesirable in the opinion of the council. However, the regulation does not require the council to provide reason for arriving at such an opinion. In effect, the international audit networks could not obtain registration for their brand names. For instance, an Indian audit firm using the first letter of the surnames of their partners had applied for registration, which resembled with the brand name of an international network.⁵⁴ The application was eventually struck down by ICAI.⁵⁵

The COE observed that the network firms are registered with ICAI and those established post-1988 have also obtained their trade/firm name under Regulation 190. Moreover, pursuant to the Revised Guidelines of Network, 2011 issued by ICAI, some of these Indian firms have entered into network arrangements with international networks, which inter alia associate those Indian firms with the brand names of their respective networks. In Type 3 networks, the sub-licensing agreement could specifically allow for use of brand name(s) of the international network by the Indian firm.

The COE observed that Part I of the First Schedule to the Chartered Accountants Act, 1949 provides that:

A chartered accountant in practice shall be deemed to be guilty of professional misconduct, if he:

(7) advertises his professional attainments or services, or uses any designation or expressions other than chartered accountant on professional documents, visiting cards, letter heads or sign boards, unless it be a degree of a University established by law in India or recognised by the Central Government or a title indicating member-ship of the Institute of Chartered Accountants of India or of any other institution that has been recognised by the Central Government or may be recognised by the Council

Similarly, the explanatory notes to Clause 7 of the ICAI’s Code of Ethics, 2009 state:

For use of logos by Members on letter heads, visiting cards etc. the Council had decided that the logos unconnected with the first letter of the name of the firm or its partners or proprietors would not be permitted for use by members in practice/firms of Chartered Accountants on their letter heads, visiting cards etc. as the same would have amounted to advertisement or smacking of publicity.

In view of these restrictions on individual CAs, the COE deliberated on whether use of brand name(s) of the international network by an Indian network firm is desirable. It was noted that audit firms with a reputed international brand name enjoy a premium globally as well as in India. Companies are willing to pay a higher price to engage them as auditors. This could potentially be because of three reasons. First, they are considered to be a potential indemnifier of losses for the stakeholders of the company. Second, they provide a better quality of audit which improves the quality of reported earnings. Third, companies may use audit firms with a reputed international brand name to ‘signal’ a superior quality of reported information. Recent research has shown that in the Indian context the demand for the big four auditors in India is primarily driven by the third factor – the need to ‘signal’ a superior quality of reported information.⁵⁶

Evidently, Indian companies benefit from the ‘signalling’ effect of using auditors with international brand names. The markets perceive information audited by the big four to be of a higher quality. Therefore, using such international brand names may be commercially advantageous to Indian companies for various reasons ranging from ease of access to foreign investment to better bonding with their clientele abroad. Prohibiting Indian audit firms from using international brand names may therefore be counter-productive for Indian companies. Moreover, it was recommended in the Report of MCA ’s Expert Group on Issues Related to Audit Firms, that branding with international affiliation would increase competitiveness of the Indian audit firms. This would also help in capacity building of the Indian audit firms through adoption of advanced audit methodologies, improve infrastructure and attract high calibre aspirants.⁵⁷ This in turn can also help the smaller and mid-sized Indian audit firms in expanding their size and business. The COE further noted that U.S., U.K. as well as China allow such branding by network members. For instance, BDO China Dahua CPA Co. Ltd., Ernst & Young Hua Ming LLP; KPMG Huazhen etc are some examples of co-branding model being used in China.⁵⁸ In view of these reasons, the COE recommends that Indian network members should be allowed to use the brand name of their respective network. To further facilitate this, the COE recommends that NFRA and ICAI should make appropriate changes to respective laws and regulations, including Regulation 190 of Chartered Accountants Regulations, 1988 and Code of Ethics, 2009.

4.5. Should Chartered Accountants and firms be allowed to advertise?

The COE recommends that CAs and CA firms should be permitted to advertise their services and solicit work subject to the following conditions:

1. A CA or CA firm shall not solicit work by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive.

2. A CA or CA firm shall not promote or market abilities to pro-vide professional services or make any claim which is false, mis-leading or deceptive.

3. A CA or CA firm shall not make exaggerate claims for services

4. A CA or CA firm shall not indulge in disparaging references or unsubstantiated comparison to the work of others.

Explanation: Promotional efforts or advertisement would be false, misleading, or deceptive if they contain any claim or representa-tion that would likely cause a reasonable person to be misled or deceived.

This would necessitate amendment to Part I of the First Schedule to the Chartered Accountants Act, 1949, and Code of Ethics, 2009.

Part I of the First Schedule to the Chartered Accountants Act, 1949 provides for professional misconduct in relation to chartered accountants in practice. With relation to advertising, it states inter alia:

A chartered accountant in practice shall be deemed to be guilty of professional misconduct, if he:

…

(6) solicits clients or professional work either directly or indirectly by circular, advertisement, personal communication or interview or by any other means:

Provided that nothing herein contained shall be construed as pre-venting or prohibiting –

(i) any chartered accountant from applying or requesting for or invit-ing or securing professional work from another chartered accountant in practice; or

(ii) a member from responding to tenders or enquiries issued by various users of professional services or organisations from time to time and securing professional work as a consequence;

(7) advertises his professional attainments or services, or

uses any designation or expressions other than chartered accountant on professional documents, visiting cards, letter heads or sign boards, unless it be a degree of a University established by law in India or recognised by the CentralGovernment or a title indicating membership of the Institute of Chartered Accountants of India or of any other institution that has been recognised by the Central Government or may be recognised by the Council:

Provided that a member in practice may advertise through a write up setting out the services provided by him or his firm and particulars of his firm subject to such guidelines as may be issued by the Council;

The COE noted that since these restrictions stem from the Chartered Accoun-tants Act, 1949, they apply to network members which are Indian CA firms registered with ICAI under the Chartered Accountants Act, 1949.⁵⁹ However, network members which are Indian entities but are not practicing as CAs (for ex-ample, offering consultancy services), are not bound by these prohibitions under the Chartered Accountants Act, 1949. This creates an opportunity for networks to engage in a regulatory arbitrage. As the Report of MCA ’s Expert Group on Issues Related to Audit Firms observed, these networks take advantage of this differential regulatory standards by making surrogate advertisements by virtue of their consultancy services, circumventing the prohibitions on advertisements by ICAI.⁶⁰ Although, such practice may not be illegal, such regulatory arbitrage may raise questions about the efficacy of such restrictions on advertisements in the first place.

The COE is of the view that to create a level playing field between network firms and non-network firms as well as individual CAs, it is essential that advertisements by all CAs are allowed subject to reasonable restrictions. This is

in tune with the decision by ICAI to relax restrictions on advertising, issuance of brochures and hosting of websites by Indian CA firms.⁶¹ Recently, the ICAI has issued the draft Code of Ethics, 2017 derived from the International Ethics Standards Board for Accountants (IESBA) code of ethics issued by the IFAC.

The COE has looked at the global best practices on advertisement and marketing in the auditing landscape. For instance, the Accounting Professional and Ethical Standards Board (APESB) in Australia allows solicitation of work by public accountants through advertisement, but requires conformity with two necessary conditions. First, there should be no exaggerated claims for services offered. Second, such practices should not amount to disparaging references or unsubstantiated comparison to the work of others. Further, it provides that in the event of any doubt, the member is required to consult the professional body.⁶² Similarly in the U.S., there is no restriction on solicitation of work through advertisement and promotion, subject to certain conditions. The code laid down by AICPA states that a member shall not solicit work by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive. Further, it prohibits member from promoting or marketing abilities to provide professional services or make any claim which is false, misleading or deceptive. The code also clarifies that:⁶³

promotional efforts would be false, misleading, or deceptive if they contain any claim or representation that would likely cause a rea-sonable person to be misled or deceived.

The COE after looking at the international best practices observed that it would be inappropriate to impose blanket restriction on solicitation of work by CAs or CAs firms through advertisement, provided certain conditions are met to avoid self-interest threat. Further, it also noted that the global trend indicates principle based restriction on solicitation of work against a prescriptive approach which is currently the position under the Chartered Accountants Act, 1949 and Code of Ethics, 2009. Therefore, there is a need to move towards a principle based approach and give freedom to the CAs or CAs firms to solicit work through advertisement subject to certain checks and balances.

Box 5: IESBA code of ethics on marketing

The IESBA code of ethics has been issued by IFAC, which is an independent standard-setting board. IFAC develops and issues ethical standards and other pronouncements for professional accountants worldwide. It has prescribed the following code for marketing professional services: ^a

• When a professional accountant in public practice solicits new work through advertising or other forms of marketing, there may be potential threats to compliance with the fundamental principles. For example, a self-interest threat to compliance with the principle of professional behavior is created if services, achievements or products are marketed in a way that is inconsistent with that principle.
• A professional accountant in public practice should not bring the profession into disrepute when marketing professional services. The professional accountant in public practice should be honest and truthful and should not:

– Make exaggerated claims for services offered, qualifications possessed or experience gained; or

– Make disparaging references to unsubstantiated comparisons to the work of another.

a. Section 250, International Federation of Accountants, IESBA Code of Ethics.

4.6. Should auditors, firms and networks be prohibited from providing non-audit services to auditee companies?

The COE recommends the following measures to address the prob-lem of conflict of interest in providing non-audit services to an audi-tee company or its holding company or subsidiary company:

1. If the auditor is a part/member of an international network, the non-audit fees earned by such network from a listed auditee company or its holding company or subsidiary companies in a financial year shall be maximum 50% of the statutory audit fee earned by that network from that auditee company or its holding company or subsidiary companies in a financial year.

2. Such auditor must separately disclose to NFRA the audit as well as non-audit fees earned by its network from each of its listed auditee company or its holding or subsidiary companies.

The auditor shall also file a declaration with NFRA stating that revenue earned from non-audit services is not in excess of 50% of the statutory audit fee earned by its network from that listed auditee company or its holding company or subsidiary compa-nies in a financial year.

3. The prohibited list of non-audit services under section 144 of the Companies Act, 2013 must include all kinds of taxation, valuation and restructuring services provided to the auditee company or its holding company or subsidiary companies. For this, the appropriate rules should be made.

4. Details of approval given by audit committee or the board of directors to auditors for providing non-audit services should be separately disclosed in the board report of the auditee company or its holding company or subsidiary companies. The board report should also contain a description of the necessary safe-guards in place to protect the independence and objectivity of such auditors providing non-audit services to the auditee com-pany or its holding company or subsidiary companies. This will require necessary rules under section 134 of the Companies Act,2013

Explanation: Entities in the network should include:

• Entities covered in Explanation (i) and (ii) of section 144 of the Companies Act, 2013 depending on whether the auditor is an individual or firm.
• Entities covered within the meaning of ‘network’ under the Re-vised Guidelines of Network, 2011 whether registered with ICAI or not.
• Affiliates which, regardless of its legal form, are connected to a network firm by means of common ownership, control or man-

Explanation: NFRA would regulate auditors of all listed companies, and unlisted public companies beyond a certain threshold, as pre-scribed by the government.

Since the collapse of Enron and the demise of Aurther Andersen, there has been public concern about the extent to which audit firms are providing non-audit services to their audit clients. Such non-audit services could range from system design to compliance related services like taxation and accounting. The concerns regarding such non-audit services are two-fold: first, auditors may not stand up to the management of the auditee company because the auditors wish to retain the additional income from non-audit services to the company; second, providing a range of services to the management may lead to the auditor identifying too closely with the management’s interests and lose their professional skepticism. For instance, in the Enron case, it has been widely reported that Andersen received $25 million in audit fees and $27 million for non-audit services.⁶⁴ These developments fuelled concerns that provision of non-audit services compromise auditor independence and nudged the legislative changes.

Policymakers globally have responded by prohibiting auditors from performing some specific non-audit functions. For instance, Sarbanes Oxley Act, 2002 in U.S. prohibited auditors from providing eight specific categories of non-audit services to their auditee companies.⁶⁵ A similar list was also introduced in 2016 in the European Union for auditors of public listed companies. This prohibits eleven category of services comprising of further sub-categories.⁶⁶ Auditors were prohibited from providing non-audit services like tax, consultancy, and advisory services to the audited entity; services that involve playing any part in the management or decision-making of the audited entity; services linked to the financing, capital structure and allocation, and investment strategy of the audited entity.⁶⁷ Similar position has been adopted in jurisdictions like U.K. and Australia.⁶⁸

Policymakers globally have also intensely debated the need to impose a cap on the non-audit fees of audit firms. For instance, the SEC has long been concerned about the potential impact of audit and non-audit fees on auditor independence. It has repeatedly asserted that auditors must be independent in fact and in appearance. Independence-in-fact is defined by SEC as the auditor’s mental state lacking any bias, while independence-in-appearance is a public perception that the auditor is objective and unaffected by a financial interest in the client. However, a recent study has argued that auditors’ independence-in-appearance is related to client importance (total fees from a client as a percentage of the total revenues of the audit firm) rather than non-audit fee ratio (non-audit to total fees from a client).⁶⁹

Box 6: Cap on non audit services in EU

The European Union has introduced caps on fees from non-auditing services to Public Interest Entities (PIEs) as well as a disclosure obligation on the total fees received from PIEs.^a Some of the salient features of this scheme are:

• When a statutory auditor or an audit firm has been providing non-audit services to the audited PIE for a period of three or more consecutive financial years, the total fees for such services shall be limited to a maximum of 70% of the average of the fees paid in the last three consecutive financial years for the statutory audit(s).
• There is, however, no fixed limit with regard to the amount of fees that a statutory auditor or an audit firm can receive from a given audited PIE. Instead, when the total fees received – both for audit and non-audit services – by a statutory auditor or an audit firm from a single PIE in each of the last three consecutive financial years exceed 15% of the total fee income received by that statutory auditor or audit firm, that fact should be disclosed to the audit committee.
• The audit committee should then consider submitting the audit engagement to a quality control review. If the fees received continue to exceed 15%, the audit committee should also consider whether the audit engagement should be kept; if so, the audit engagement can remain in place, but for a period no longer than 2 years.^b

a. PIEs are defined as listed companies, credit institutions and insurance undertakings. In addition, Member States can designate as PIEs other undertakings that are of significant public relevance, because of the nature of their business, their size or the number of their employees.

b. European Commission, Reform of the EU Statutory Audit Market – Frequently Asked Questions.

Indian position

The Indian debate on conflict of interest related to non-audit services was triggered immediately after the Enron scandal. In 2002, the committee headed by Naresh Chandra deliberated over the issue of non-audit services and recom-mended the position adopted in U.S. under the Sarbanes Oxley Act, 2002.⁷⁰ Consequently, India adopted a similar approach by prohibiting auditors from performing specific non-audit services in the new Companies Act, 2013 (see, ta-ble 4.1) .⁷¹ If the auditor is a firm, this prohibition is applicable to its associated entity or any entity whatsoever in which the firm has significant influence or control or whose brand name is used by such audit firm or its partners.⁷²

Companies Act, 2013	Sarbanes Oxley Act, 2002 Sarbanes Oxley Act, 200
Book-keeping	Book-keeping
Internal Audit	Internal Audit
Financial information systems	Financial information systems
Actuarial services	Actuarial services
Investment and banking Advisory	Investment and banking Advisory
Outsourced financial services	Appraisal or valuation services, fairness opinion
Management function	Management or human resource function
Any other services	Legal/expert services unrelated to audit

Table 4.1.: Comparison of prohibited non-audit services

While section 144 of the Companies Act, 2013 provides an exhaustive list of prohibited non-audit services, it also authorises the government to prescribe any other kind of services in this list. The COE has noted that there could be a case of self-review risk if certain services are allowed to be provided by the auditor. Therefore, there is a need to revisit the list keeping in view the various kinds of services rendered by auditors which can possibly result in conflict of interest. The international practice (EU, Australia, U.K.) shows prohibition on non-audit services like taxation, restructuring and valuation since they are likely to influence the objectivity and independence of auditors. Presently, these services are permitted in India. Therefore, the COE is of the view that the list prescribed under section 144 of the Companies Act, 2013 needs to be expanded.

Presently, there is a cap which requires that non-audit services fee earned by statutory auditor along with its associate concern or corporate bodies must not exceed the aggregate statutory audit fee.⁷³ However, this cap was set in 2002 by ICAI and since then the market of non-audit services has evolved. Therefore, the COE is of the view that this cap on non-audit services needs to be reviewed. Taking into account, the international position, especially in European Union and U.K., the COE recommends a cap on fee earned from non-audit services which shall not be more than 50% of the audit fee paid to the auditor by the listed auditee company or its holding or subsidiary company.

Further, there is no provision in the Companies Act, 2013 which mandates disclosure of non-audit fee earned by the auditor in the financial statements of the auditee company. Recently in 2018, SEBI amended regulations which would now require a listed company to disclose total fees for all services paid by the listed entity and its subsidiaries, on a consolidated basis, to the statutory auditor and all entities in the network firm/network entity of which the statutory auditor is a part.⁷⁴ However, this disclosure obligation is on the listed entity. The COE recommends that a statutory auditor must separately disclose to NFRA the audit as well as non-audit fees earned from each of its auditee company or its holding or subsidiary companies. From the information available in the public domain, the COE noted that under the current Indian framework, NFRA would regulate auditors of all listed companies, and public companies beyond a certain threshold, as prescribed by the government.⁷⁵

The COE noted that under the Companies Act, 2013, an auditor has to obtain prior approval of the audit committee or board of the directors for providing non-audit services.⁷⁶ Similar approvals are required in other jurisdictions also. For instance, in U.S. under the Sarbanes Oxley Act, 2002, audit committee approves the types of non-audit services which can be provided to the auditee

company. Further, such approval has to be disclosed by the auditee company to investors in periodic reports.⁷⁷ Similar practice is also followed in U.K. where The UK Corporate Governance Code, 2016 requires audit committee to develop and implement the policy on engagement of external auditor to supply non-audit services. Further, the annual report must contain a separate section describing how the audit committee has safeguarded the objectivity and independence of auditors providing non-audit services.⁷⁸ Therefore, keeping in view the best international practices, the COE recommends that the approval of audit committee or board of directors given to auditors to provide non-audit services should be separately disclosed in the annual report of the auditee company along with a description of the necessary safeguards in place to protect the independence and objectivity of the auditors.

The Enron scandal lead to Sarbanes Oxley Act, 2002 which reduced the scope of non-audit services to address the issue of conflict of interest. This nudged several international audit firms to sell off their consultancy venture. However, over the years, they have re-established their presence in this domain.⁷⁹ These consulting entities are members of the global network.⁸⁰ The COE after exam-ining inputs from various stakeholders observed that there is a likelihood that substantial amount of non-audit services are provided to an auditee company by network entities belonging to the same network of which the auditor is also a member/part.⁸¹ The COE is of the view that such a likelihood of serious conflict of interest within a network compromises the independence – in-fact as well as in-appearance – of auditors/audit firms within that network.

Further, the government may consider placing a cap on the maximum number of statutory audit of public companies by an audit firm.

4.7. Is the current Indian legal regime of liability of auditors, audit firms and the networks adequate?

1. The COE concludes that the current Indian legal regime on liability of individual auditors and audit firms is adequate.

2. The COE on the issue of network liability recommends that NFRA should be explicitly empowered by law to impose civil liability in the form of monetary penalties on the international network/entity with whom/which the Indian audit firm has en-tered into networking/membership, if any audit failure or fraud is found to have been caused due to any faulty methodology be-ing followed by that particular network.

Explanation: The amount of penalty to be imposed on such international network/entity shall be upto five (5) times the amount of penalty imposed on the audit firm.

3. To enable NFRA to perform this function, every auditor and audit firm, which is operating in India as a part/member of an international network, must submit an Annual Transparency Report to NFRA, disclosing the following:

• A description of the network, its legal and structural ar-rangements, including payment of any fees, costs, grants, etc between the Indian audit firm and its network entities, directly or indirectly;
• Details of ownership and management structure of the out-side entity or entities constituting the network;
• The name and registered office, central administration or principal place of business, of each network member oper-ating in India as a sole practitioner or audit firm;
• The name and registered office, central administration or principal place of business, of each affiliate of the networkoperating in India;
• The total turnover achieved by network members operating as sole practitioners and audit firms as well as network affiliates operating in India; and
• The internal standard audit methodology followed by all the network firms globally and in India.

For these disclosure requirements, the COE recommends nec-essary provision in the NFRA rules which are presently under consideration.

Explanation I: NFRA would regulate auditors of all listed com-panies, and public companies beyond a certain threshold, as notified by the government.

Explanation II: ‘Affiliate’ means any entity, regardless of its legal form, which is connected to a firm by means of common ownership, control or management.

Legal liability on auditors for an audit failure or fraud is necessary mainly for three reasons. First, legal liability on auditors is necessary to deter any intentional breach of duties or fraudulent behaviour. Second, legal liability is necessary to disgorge any unlawful gains made by an auditor. However, it not enough to merely restore the auditor back to the position it was before committing a breach or fraud. Third, it is important to ensure that direct victims of an audit failure or fraud are also compensated by the auditor. Such compensation by the auditor for audit failure or fraud represents a form of implicit insurance to outside investors. Such an insurance provided by the auditor enables the entrepreneur to raise capital from such investors at lower cost.⁸²

However, excessive imposition of liability on auditors could be counterproductive. First, excessive legal liability could drive auditors out of the market, making it more concentrated with fewer auditors. Second, a higher risk of legal liability on auditors could drive up their audit fees, making mandatory audit costly for all companies. Third, auditors may refuse to audit riskier companies, making

it difficult for such companies to raise capital. Recent research shows that the relationship between the strength of the legal liability regime and the client rejection rate is U-shaped. In other words, clients are less likely to be rejected in environments with moderate legal regime, as compared to environments with relatively strong or relatively weak legal regime.⁸³

Taking into account the pros and cons of legal liability on auditors, the COE is of the view that it is important that the Indian legal regime on auditors’ liability should take a balanced approach. From this perspective, the COE analysed the current Indian legal regime on auditors’ liability to identify the nature of sanctions that could be imposed against individual auditors as well as audit firms in case of a fraud. The COE reviewed the relevant provision under Chartered Accountants Act, 1949 as shown in Table 4.3 and those under Companies Act, 2013 as shown in Table 4.4.

Sections	Application	Criminal Civil	sanction sanction
21A	CA found guilty of profes-sional or other misconduct under Schedule I	NA	Board of Discipline can reprimand the CA, remove the name of the CA from the register up to a period of 3 months, and/or impose fine up to Rs. 1 lakh
21B	CA found guilty of profes-sional or other misconduct under Schedule II or both Schedules I and II	NA	Disciplinary Committee can repri-mand the CA, remove the name of the CA from the register perma-nently or temporarily, and/or im-pose fine up to Rs. 5 lakhs

Table 4.3.: Chartered Accountants Act 1949

As is evident from these tables there are various criminal sanctions that could be imposed on individual auditors as well as audit firms involved in any audit failure or fraud. It is important to note that the amount levied in the form of ‘fine’ goes to the consolidated fund of India and not to the investors of the company.⁸⁴ Therefore, these criminal sanctions can only have a deterrence function and do not serve any indemnification function.

In contrast, there are three provisions on civil sanctions that provide for indem-nification to users of the faulty audited financial statements. These are section 132(4)(c), section 147(3)(ii) and section 245(1)(g)(ii) under the Companies Act, 2013 as shown in Table 4.4. The COE noted that section 132(4)(c) empowers NFRA to impose monetary penalty on auditors as well as audit firms including debarment. Under section 147(3) (ii) an auditor or audit firm which is convicted under section 147(2), is liable to pay damages to the potential users of its audited financial statements. Finally, section 245(1) could be used by NCLT to award damages or compensation against auditor including audit firms for improper or misleading statements made in audit report or for any fraudulent, unlawful or wrongful act or conduct.

On review of the above provisions, the COE is of the view that the current Indian regime on auditor liability provides for all three functions – deterrence, disgorgement as well as indemnification. Accordingly, the COE concludes that the current Indian legal regime on liability of individual auditors and audit firms is adequate.

Network liability

The COE noted that an audit failure or fraud could happen because of two reasons. First, it could be due to lapses on the part of the auditor or audit firm because of which proper audit methodology is not followed or observed. As discussed earlier, there are various provisions in the law to hold the auditor or audit firm liable for such a lapse being a fault on the part of the auditor or the audit firm. Second, an audit failure or fraud could also happen because the audit method followed by auditor or audit firm as part of a network is itself flawed. Since this is a fault of the method being followed by the network itself, in such cases, it is important that NFRA has the power to extend the liability on the network. Therefore, the COE recommends that NFRA should be explicitly empowered by law to impose civil liability in the form of monetary penalties on the international network/entity with who/which the Indian audit firm has entered into networking/membership agreement, if any audit failure or fraud is found to have been caused due to any faulty methodology being followed by that particular network.⁸⁵

Box 7: Network liability on Big Four

The COE noted that network liability of big four firms has been recognised in other jurisdiction also. In 2017, the Italian Competition Authority (ICA) imposed a fine of 23 million Euro on the big four firms for indulging in cartelisation in a tender contract. The big four had entered into a horizontal and secret agreement aimed at conditioning the dynamics of the tender in order to avoid competition in the award of contracts. a The ICA observed that in Italy a consulting firm and an audit firm co-exist in every big four network: this division is for regulatory reasons. It was found that despite this formal subdivision, all the companies involved in the proceedings belonging to the same networks had acted in a coordinated manner as a single economic entity. b To arrive at this conclusion, the ICA observed that each entity in the network is identified by the same brand, shared professional and structural resources, shared common offices, adopted unitary communication strategies and used the same website as a tool to promote the entire range of services offered by the network. Therefore, each network which consisted of (KPMG & KPMG Advisory); (EY & EY Business Advisory); (PWC & PWC Advisory); and (Deloitte & Touche and Deloitte Consulting) was made jointly and severally liable for paying the penalty.c

___________________

a. Scavuzzo, “The Italian Competition Authority (AGCM) has fined the ’Big Four’ consultancy firms following a serious infringement of Article 101 TFEU in a public tender for audit services”, p. 6.

b. Depau, “Bid Rigging Practices Aimed at Manipulating Consip’s Tender in the Market of Cleaning Services For Public Instiutions (I785)”.

c. Depau, “Bid Rigging Practices Aimed at Manipulating Consip’s Tender in the Market of Cleaning Services For Public Instiutions (I785)”.

The COE observed that European Union has imposed a higher liability on auditors of listed companies. To achieve this, the Regulation (EU) No 537/2014 Of the European Parliament and of the Council has imposed legal obligations on auditors and audit firms to disclose financial information at the level of the network to which such auditors belong.⁸⁶ The COE is of the opinion that a similar disclosure obligation has to be placed on all members of a network operating in India to enable NFRA to impose monetary penalty on such members in the event of a process failure at the network level leading to an audit failure or fraud.

The COE recommends that every auditor and audit firm, which is operating in India as a member/part of an international network, must submit an Annual Transparency Report to NFRA, disclosing the following:87

• A description of the network, its legal and structural arrangements, in-cluding payment of any fees, costs, grants, etc between the Indian audit firm and its network firms and affiliates, directly or indirectly;
• Details of ownership and management structure of the outside entity or entities constituting the network;
• The name and registered office, central administration or principal place of business, of each network member operating in India as a sole practitioner or audit firm;
• The name and registered office, central administration or principal place of business, of each affiliate of the network operating in India;
• The total turnover achieved by network members operating as sole prac-titioners and audit firms as well as network affiliates operating in India; and
• The internal standard audit methodology followed by all the network firms globally and in India.

Explanation II: ‘Affiliate’ means any entity, regardless of its legal form, which is connected to a firm by means of common ownership, control or management.

This information available from the Annual Transparency Report will help NFRA keep track of the auditors and audit firms operating in India as part of the same network so that in case any legal liability needs to be imposed on that particular network for an audit failure or fraud.

4.8. Whether network firms violate section 25 of the Chartered Accountants Act, 1949?

The COE observed that when a CA signs a document as such, claim-ing to practice on behalf of a company or a limited liability part-nership which has a company as its partner, it would amount to a violation of section 25. Although no instance of such malpractice was brought before the COE, the COE recommends that to prevent any such potential malpractice, ICAI should amend the Chartered Ac-countants Regulations, 1988 to explicitly prohibit a CA from signing on behalf of any company.

Section 25 of the Chartered Accountants Act, 1949 states:

(1) No company, whether incorporated in India or elsewhere, shall practise as chartered accountants.

[Explanation – For the removal of doubts, it is hereby declared that the ‘company’shall include any limited liability partnership which has company as its partner for the purposes of this section.]

(2) If any company contravenes the provisions of sub-section (1), then, without prejudice to any other proceedings which may be taken against the company, every director, manager, secretary and any other officer thereof who is knowingly a party to such contravention shall be punishable with fine which may extend on first conviction to one thousand rupees, and on any subsequent conviction to five thousand rupees.

Since the application of this section depends on the meaning of the words ‘practise as chartered accountants’, it is relevant to consider section 2(2) of Chartered Accountants Act, 1949 which states:

(2) A member of the Institute shall be deemed ‘to be in practice’, when individually or in partnership with chartered accountants [in practice] [or in partnership with members of such other recog-nised professions as may be prescribed], he, in consideration of remuneration received or to be received –

(i) engages himself in the practice of accountancy; or

(ii) offers to perform or performs services involving the auditing or verification of financial transactions, books, accounts or records, or the preparation, verification or certification of financial accounting and related statements or holds himself out to the public as an accountant; or

(iii) renders professional services or assistance in or about matters of principle or detail relating to accounting procedure or the recording, presentation or certification of financial facts or data; or]

(iv) renders such other services as, in the opinion of the Council, are or may be rendered by a chartered accountant [in practice];

and the words ‘to be in practice’with their grammatical variations and cognate expressions shall be construed accordingly.

Explanation: An associate or a fellow of the Institute who is a salaried employee of a chartered accountant [in practice] or [a firm of such chartered accountants or firm consisting of one or more char-tered accountants and members of any other professional body having prescribed qualifications] shall, notwithstanding such employment, be deemed to be in practice for the limited purpose of the [training of articled [assistants].

The Study Group Report, 2003 had suggested that section 2(2) of the Chartered Accountants Act, 1949 could be interpreted such that all functions specified under section 2(2) are reserved for chartered accountants only subject to those exceptions specifically excluded by any statute.88 The COE found it difficult to agree with the said interpretation.

The COE noted that section 2(2) does not prohibit persons, who are not members of ICAI (hereinafter referred to as ‘lay persons’), from providing the services mentioned in section 2(2)(i)-(iv). It merely deems a member of ICAI to be in practice if she is engaged in providing the said services. In contrast, if the same services are provided by a lay person, such lay person is not deemed to be in practice. A contrary interpretation would suggest that ICAI has unfettered discretion under section 2(2) (iv) to expand the exclusive areas of practice for chartered accountants to any other profession or vocation. Such an interpretation would be arbitrary and unworkable. Therefore, the COE is of the view that section 2(2) does not provide any exclusive domain of practice to chartered accountants and any lay person can also provide the services mentioned therein.

This is relevant because certain other statutes bestow chartered accountants with the exclusive privilege of auditing accounts or attesting documents. For example, under Companies Act, 2013 only a CA is eligible for appointment as an auditor of a company.89 Similarly, under Income Tax Act, 1961 only a chartered accountant can audit accounts of certain persons carrying out business or profession.90 Therefore, most of the exclusive privileges enjoyed by chartered accountants stem from various other statutes than from the Chartered Accountants Act, 1949.

The COE noted that section 25 is violated if a company or a limited liability partnership which has a company as its partner, practices as CAs. In other words, when a CA signs a document as such claiming to practice on behalf of a company or a limited liability partnership which has a company as its partner, it would amount to a violation of section 25. No instance of such malpractice was brought before the COE. However, in light of this discussion, the COE is of the view that to prevent any such potential malpractice of the nature mentioned above, ICAI should amend the Chartered Accountants Regulations, 1988 to explicitly prohibit a CA from signing on behalf of any company.

4.9. Whether audit firms by being members of international networks violate the reciprocity requirement under section 29 of the Chartered Accountants Act, 1949?

The COE concluded that the Indian audit firms which are members of international networks are set up as partnerships or LLPs under Indian laws and all their partners are members of the ICAI. There-fore, the COE is of the view that there is no question of violation of the reciprocity requirement under section 29 of the Chartered Accountants Act, 1949.

Section 29 of the Chartered Accountants Act, 1949 states as follows:

(1) Where any country, specified by the Central Government in this behalf by notification in the official Gazette, prevents persons of Indian domicile from becoming members of any institution similar to the Institute of Chartered Accountants of India or from practising the profession of accountancy or subjects them to unfair discrimina-tion in that country, no subject of any such country shall be entitled to become a member of the Institute or practise the profession of accountancy in India.

(2) Subject to the provisions of sub-section (1), the Council may prescribe the conditions, if any, subject to which foreign qualifications relating to accountancy shall be recognised for the purposes of entry in the Register.

Evidently, this provision is aimed at persons who are subjects of any foreign jurisdiction. Such persons shall be entitled to become a member of ICAI or practice as an accountant in India only if that foreign jurisdiction does not prevent such privilege being extended to persons domiciled in India.

The COE noted that ICAI has taken active initiatives by entering into Memo-randums of Understanding (MoUs) with its counterpart institutions in several foreign jurisdictions.91 Several of such MoUs have also been approved as Mu-tual Recognition Agreements (MRAs) by the Union Cabinet of India. As a result of such MRAs, Indian qualified chartered accountants are recognised as charted accountants in those foreign jurisdictions subject to certain examination requirements.

As has been mentioned earlier, Indian audit firms which are members of inter-national networks are set up as partnerships or LLPs under Indian laws and all their partners are members of the ICAI. Therefore, the COE is of the view that

there is no question of violation of the reciprocity requirement under section 29 of the Chartered Accountants Act, 1949.

4.10. What measures could be taken to promote multi-disciplinary practice firms?

The COE recommends that development of MDPs should be facil-itated in India by rationalising the Advocates Act, 1961 using the template of UK Legal Services Act, 2007 as a starting point.

The Report of MCA ’s ETpert Group on Issues Related to Audit Firms expressed the vision that India as a global power in services should aspire to have its own audit firms at international level which provides services internationally, particularly in developing countries. Yet, Indian audit firms continue to remain chronically small. The country has as many as 43,000 audit firms, of which as many as three-fourths are single person proprietary firms. Less than 200 firms (0.5%) have more than 10 partners.92

One major hurdle in the growth of Indian audit firms is the lack of development in MDPs in India. Quality auditing requires specialists in many areas like law, valuation, IT systems, acturial etc. The need for specialisation increases with the complexity of the business model of the client. For instance, audits of clients with complex IT systems like banks and insurance companies require extensive involvement of IT specialists. A narrow approach to audit would have serious implications for attracting talent and developing expertise. Without such expertise and breadth of talent, Indian chartered accountant firms, especially the non-network firms, would be unable to provide depth of industry expertise to their clients. Not only is this detrimental for the growth of Indian audit firms but even for the Indian economy as a whole. A fast growing economy like India is developing highly complex businesses in the financial as well as non-financial sectors. Auditors need to develop adequate capacity to be able to effectively assess the risks in such businesses and must act swiftly to resolve issues as they arise. Recent reforms like the Insolvency and Bankruptcy Code, 2016 highlight the importance of chartered accountants, valuers and lawyers working together efficiently in resolving the huge volumes of stressed assets across sectors. Even during the stakeholders’ meetings it emerged that most of them including audit firms, professional institutes and industry associations favour development of MDPs in India. Therefore, the COE is strongly of the view that MDPs are the need of the hour for the Indian economy.

The COE noted that in recent times legislative and regulatory reforms have been initiated to recognise MDPs. Section 141(1) of the Companies Act, 2013 envisages the possibility of MDP. Even the Chartered Acco’untants Act, 1949 was amended in 2012 to allow CAs to form partnerships with members of other recognised professions as may be prescribed by ICAI.93 Similarly, Regulations 53A and 53B were added to the Chartered Acco’untants Reg’ulations, 1988 to allow partnership, fee and profit sharing as well as sharing of services among chartered accountants, company secretaries, cost and work accountants, advocates, architects and actuaries.94

However, the COE noted that the current laws and regulations of the Indian legal profession are not conducive to MDPs. For instance, in 2015 Society of Indian Law Firms (SILF) had reportedly complained to the Delhi Bar Council against PwC, Delloite, KPMG and EY for unauthorised practice of law. The main argument was the these firms had violated section 29 of the Advocates Act, 1961 and therefore, criminal sanctions under section 45 of Advocates Act should be imposed on them.95 Even before the Hon’ble Supreme Court of India in Bar Co’uncil of India v.A.K. Balaji and Ors. it was alleged that many accountancy and management firms are employing law graduates who are rendering legal services in alleged violation of the Advocates Act, 1961.96 In spite of these legal complications, law firms are diversifying into MDPs like forensic operations and undertaking commercial diligence and investigations for their clients. For instance, AZB & Partners reportedly hired up six forensic experts from EY.97 In light of these complications, fundamental legal reforms would be necessary to facilitate development of MDPs in India.

To understand how other jurisdictions have reformed their laws and regulations to promote MDPs, the COE reviewed the developments in UK in view of the common law origins of the Indian legal profession. Prior to 2009, non-lawyer

Figure 4.4.: Total net capital expenditure as a percentage of annual turnover (ONS, UK Wide) for selected service industries (Source: Legal Services Board)

partnerships were prohibited in UK. However, this changed when the Legal Services Board (LSB) established under the Legal Services Act, 2007 issued new regulations in 2011 allowing complete non-lawyer ownership of law firms. Such firms are designated as Alternative Business Structures (ABS).98

The COE observed that after UK allowed complete non-lawyer ownership of law firms through the ABS structure, the capital expenditure in the UK legal sector has grown substantially as is evident from Figure 4.4. Prior to gaining their ABS licence, 63% of ABSs offered legal services while the remaining 37% did not offer any form of legal services before being granted an ABS licence. The main motivations for seeking an ABS licence were to promote non-lawyers to management of the business, boosting market profile, accessing external investment and succession planning. Figure 4.5 shows the steady growth in number of ABS licences issued by different licensing bodies till April 2017.99

Figure 4.5.: The growth in the number of ABS licences (Source: Legal Services Board)

Taking into account the stakeholders’ demands as well as global developments, the COE is of the view that MDPs would be beneficial for Indian corporates. In sync with this demand, law firms as well as audit firms are already expanding the portfolio of services they offer to their clients. However, archaic laws and regulations, especially the ones on the legal profession, impose unnecessary hurdles in the smooth development of MDPs. For Indian firms to evolve into global leaders in auditing, legal, consultancy, and ancilliary services, it is necessary to rationalise the Advocates Act, 1961 to facilitate development of Indian law firms as well as audit firms into MDPs. The UK Legal Services Act, 2007 provides a useful template which could serve as a starting point for Indian legal reforms.

4.11. How should FEMA and its regulations be enforced on auditors, firms and networks?

In view of the claim by the audit firm that the foreign funds have been received by it in the form of grants and not as capital, RBI has stated that then it is not a question of violation or enforcement of FEMA per se. However, this has to be seen by the Ministry of Home Affairs (MHA) from the perspective of the Foreign Contri-bution (Regulation) Act, 2010. From the point of view of the COE, only MHA can verify the veracity of this claim of the audit firm to settle it towards finality.

Under the Foreign Direct Investment (FDI) policy, a non-resident entity can invest in India, except in those sectors/activities which are prohibited.100 This seems to suggest that there is currently no restriction in foreign investment in auditing and consultancy services. However, as per para 5.2 of Consolidated FDI Policy, 2017, FDI is further subject to sectoral laws and regulations. The COE also noted that presently an entity incorporated outside India may contribute to the capital of an LLP operating in sectors/activities where foreign investment upto 100% is permitted under the automatic route.101

The Supreme Court in its judgment dated February 23, 2018 raised the issue of remittance from outside India and its alleged application to acquire Indian audit firms. The Supreme Court observed:

It is an undisputed fact that there are remittances from outside India. The same could be termed as investment even though the remittances are claimed to be interest free loans to partners. The amount could also be for taking over an Indian chartered accoun-tancy firm. Relationship of partnership firms, though having Indian partners, operating under a common brand name from same in-frastructure, with foreign entity is not ruled out. It is not possible to rule out violation of FDI policies, FEMA Regulations and the CA Act. Thus, appropriate action may have to be taken in pending proceedings or initiated at appropriate forum. (para 45)

In the present context, having regard to the statutory framework under the CA Act, current FDI Policy and the RBI Circulars, it may prima facie appear that there is violation of statutory provisions and policy framework effective enforcement of which has to be ensured. (para 50)

For this purpose, the COE sought clarification from the concerned audit firm (Price Waterhouse) and in its submission it has been stated that funds received by it from outside India are in the nature of grants.102 The COE is not in a position to comment on the reply of PW about the nature of funds.

The COE also consulted RBI as a relevant stakeholder, for its clarification on the issue of alleged violation of Foreign Exchange Management Act, 1999/rules/regulations or FDI policy by the audit firms which are part of the international network. The COE also sought suggestions from RBI for better enforcement of the FDI policy and the FEMA regulations.

The RBI in its response stated that:

As per the submissions made in this matter, the Audit companies have claimed that the foreign funds have been received by them in the form of grants and no capital instruments have been issued. Therefore, it is not a question of violation or enforcement of FEMA Regulations per se. However, this issue may come under the purview of Foreign Contribution Regulation Act (FCRA) administered by MHA and it can be examined from the perspective of donation/ grant.As far as outward payments by such Audit companies (in the form of membership fees) is concerned, MCA may consider seeking clarification from these companies as to the manner and amounts which is being sent and under which legal provisions.

In view of the claim by the audit firm that the foreign funds have been received by it in the form of grants and not as capital, RBI has stated that then it is not a question of violation or enforcement of FEMA per se. However, this has to be seen by the MHA from the perspective of the Foreign Contribution (Regulation) Act, 2010. From the point of view of the COE, only MHA can verify the veracity of this claim of the audit firm to settle it towards finality.

Notes:-

1. Armour, Awrey, et al., Principles of Financial Regulation.

2. Kraakman et al., The Anatomy of Corporate Law, pp. 29-30.

3. Armour, Awrey, et al., Principles of Financial Regulation, p. 121.

4. Armour, Hansmann, and Kraakman, “Agency Problems, Legal Strategies and Enforcement”, p.6.

5. The Institute of Chartered Accountants in England and Wales, Agency theory and the role of audit, pp. 6-7.

6. Armour, Hansmann, and Kraakman, “Agency Problems, Legal Strategies and Enforcement”, p.9.

7. Armour, Awrey, et al., Principles of Financial Regulation, p. 122.

8. Armour, Awrey, et al., Principles of Financial Regulation, p. 122.

9. Laux and Newman, “Auditor Liability and Client Acceptance Decisions”, p. 262.

10. Section 44AB Government of India, Income Tax Act.

11. Gavious, “Alternative perspectives to deal with auditors’ agency problem”, p. 458. ‘²Dontoh, Ronen, and Sarath, “Financial Statements Insurance”, p. 3.

13. Dontoh, Ronen, and Sarath, “Financial Statements Insurance”, p. 3.

14. This is based on the definition used by EU. See Article 2(7), European Parliament, DIREC-TIVE 2006/43/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amend-ing Council Directives 78/ 660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC, a similar definition has been adopted in India.

15. Armour, Awrey, et al., Principles of Financial Regulation, p. 122.

16. Armour, Awrey, et al., Principles of Financial Regulation, p. 132.

17. Armour, Awrey, et al., Principles of Financial Regulation, pp. 132-133.

18. Government of India, Report of the Financial Sector Legislative Reforms Commission, Volume I: Analysis and Recommendations, p. xiv.

19. Armour, Awrey, et al., Principles of Financial Regulation; Davies and Worthington, Principles of Modern Company Law, p. 808.

–

1. Auditors were used by guilds, monastries, priories, manors, joint stock companies from the thirteenth to the seventeenth century. See Watts and Zimmerman, “The market for independence and independent auditors”; also see, Boockholdt, “A historical perspective on the auditor’s role: The early experience of the American railroads”.

2. The first bankruptcy statute was passed in England in 1825. The role of professional accountants in bankruptcy increased under the subsequent bankruptcy statutes of 1848, 1861 and 1869. These statutes required appointment of assignees by courts or allowed creditors to appoint trustees. Watts and Zimmerman, “The market for independence and independent auditors”.

3. Boockholdt, “A historical perspective on the auditor’s role: The early experience of the American railroads”; subsequently, sectoral statutes mandated audits for various industries like Railway Companies Act, 1867-1879; Banking Companies Act, 1879; and Water Com-panies Act, 1871. Watts and Zimmerman, “The market for independence and independent auditors”.

4. Watts and Zimmerman, “The market for independence and independent auditors”.

5. Accountants were initially hired to assist shareholder audit committees constituted by certain American companies, usually railroad companies. Although initially these auditors were used for investigation of frauds and verification of account balances, some companies chose to publish statements from their auditors in their annual reports. Thus developed the role of auditors in reporting the companies’ financial status to its shareholders. Boockholdt, “A historical perspective on the auditor’s role: The early experience of the American railroads”.

6. During 1880-1900, the huge expansion of American manufacturing firms was heavily financed through the London capital markets. As a consequence, English auditors with established brand-names entered the American market during 1880s. Watts and Zimmerman, “The market for independence and independent auditors”.

7. Watts and Zimmerman, “The market for independence and independent auditors”.

8. Watts and Zimmerman, “The market for independence and independent auditors”.

9. Sunder, “Rethinking the Structure of Accounting And Auditing”, p. 13.

10. For instance, physical inspection of inventories and confirmation of receivables were optional until fraudulent activities in McKesson & Robbins emerged in 1939. Byrnes et al., “Evolution of Auditing: From the Traditional Approach to the Future Audit”.

11. Statement on Auditing Procedure (SAP) No. 1 issued in October 1939, Byrnes et al.,

12. Evolution of Auditing: From the Traditional Approach to the Future Audit”. ‘²Watts and Zimmerman, “The market for independence and independent auditors”.

13. Evans, The regulatory framework for public accounting.

14. Rule 102(e), U.S. Securities and Exchange Commission, Rules of Practice.

15. H. Williams, The 1980s: The future of the accounting profession.

16. Section 105(c)(4), United States of America, Sarbanes Oxley Act.

17. Section 102(a), United States of America, Sarbanes Oxley Act.

18. Section 104(a), United States of America, Sarbanes Oxley Act.

19. Section 104, United States of America, Sarbanes Oxley Act.

20. Center for Audit Quality, Guide to PCAOB Inspection, p. 12.

21. Section 106, United States of America, Sarbanes Oxley Act.

22. An alternative proposal to impose a complete ban on auditors from providing non-audit services to their clients was considered but subsequently rejected. Barrett, “”Tax services” as a trojan horse in the auditor independence provisions of Sarbanes-Oxley”.

23. Section 202, United States of America, Sarbanes Oxley Act.

24. PCAOB, Information for Auditors of Broker-Dealers.

25. Section 107, United States of America, Sarbanes Oxley Act.

26. Section 4C, United States of America, Securities Exchange Act.

27. Section 105(b)(4), United States of America, Sarbanes Oxley Act.

28. Rules 4000(c), 5100, 5200(b) and 5200(c), Public Company Accounting Oversight Board, Bylaws and Rules of The Public Company Accounting Oversight Board.

29. Financial Reporting Council, Professional Oversight Board for Accountancy, Report to the Secretary of State, p. 10.

30. Financial Reporting Council, Annual Report, p. 1.

31. United Kingdom, Companies Auditors Regulations.

32. Financial Reporting Council, Guidelines on Enforcement Measures against Recognised Supervisory Bodies and Recognised Qualifying Bodies, p. 2; See, Appendix 1-5, Financial Reporting Council, Delegation Agreement, pp. 20-25.

33. Schedule 10, United Kingdom, Companies Act.

34. Financial Reporting Council, Guidelines on Enforcement Measures against Recognised Supervisory Bodies and Recognised Qualifying Bodies, pp. 5-6.

35. Financial Reporting Council, Financial Reporting Council Governance Bible, p. 20.

36. Rule 26 and 27, Financial Reporting Council, Audit Enforcement Procedure, p. 10.

37. Section 1214, United Kingdom, Companies Act.

38. Section 1215, United Kingdom, Companies Act.

39. Auditing Practices Board, APB Ethical Standard 5.

40. Sections 493, 494, United Kingdom, Companies Act.

41. Sections 534-538 United Kingdom, Companies Act; Davies and Worthington, Principles of Modern Company Law.

42. Clarke, Chambers, and Long, Independent Review of the Financial Reporting Council’s Enforcement Procedures Sanctions.

43. UK Parliament, Business, Energy and Industrial Strategy and Work and Pensions Commit-tees of Session 2017-19, p. 80.

44. UK Parliament, Business, Energy and Industrial Strategy and Work and Pensions Commit-tees of Session 2017-19, p. 85.

45. Competition & Markets Authority, Statutory Audit Market, p. 4.

46. Turley, “The Accounting Profession in China: Review and outlook”, p. 547.

47. Gillis, “The Big Four in China: Hegemony and Counter-hegemony in the Development of the Accounting Profession in China”, pp. 94-95.

48. Turley, “The Accounting Profession in China: Review and outlook”, p. 548.

49. Gillis, “The Big Four in China: Hegemony and Counter-hegemony in the Development of the Accounting Profession in China”, p. 108.

50. Gillis, “The Big Four in China: Hegemony and Counter-hegemony in the Development of the Accounting Profession in China”, pp. 159-160.

51. Turley, “The Accounting Profession in China: Review and outlook”, p. 550.

52. Gillis, “The Big Four in China: Hegemony and Counter-hegemony in the Development of the Accounting Profession in China”, p. 125.

53. Turley, “The Accounting Profession in China: Review and outlook”, p. 553.

54. Gillis, “The Big Four in China: Hegemony and Counter-hegemony in the Development of the Accounting Profession in China”, p. 200.

55. Turley, “The Accounting Profession in China: Review and outlook”, p. 553.

56. International Federation of Accountants, IFAC: China, Legal and Regulatory Environment.

57. Article 33 and 37, People Republic of China, Law of the People Republic of China on Certified Public Accountants.

58. Article 13, People Republic of China, Law of the People Republic of China on Certified Public Accountants.

59. Article 5, Chinese Institute of Certified Public Accountants, Disciplinary Measures for Non-compliance Activities Conducted by Members of Chinese Institute of Certified Public Accountants.

60. Article 39 and 40 People Republic of China, Law of the People Republic of China on Certified

61. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 51-52.

62. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 53-57.

63. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 40-41.

64. Expert Committee on Company Law, Report of the Expert Committee on Company Law, pp. 105-108.

65. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 92-93.

66. Institute of Chartered Accountants of India, Rules of Network, p. 21.

67. Section 28B(b) Government of India, Chartered Accountants Act.

68. Sections 21, 21A and 21B, Government of India, Chartered Accountants Act.

69. Institute of Chartered Acccountants of India, Expert Group Report, pp. 143-154.

70. Standing Committee on Finance, Standing Committee on Finance 21st Report on The Companies Bill, 2009, pp. 34-37.

71. Standing Committee on Finance, Standing Committee on Finance 21st Report on The Companies Bill, 2009, para 9.23.

72. Confederation of Indian Industry, Second Naresh Chandra Committee, pp. 15-17.

73. Standing Committee on Finance, Standing Committee on Finance 21st Report on The Companies Bill, 2009, para 10.50.

74. Section 132, Government of India, Companies Act.

75. Section 132, Government of India, Companies Act.

76. Para 9.9, Companies Law Committee, Report of the Company Law Committee, p. 41.

77. Rajya Sabha, Delay in Constitution of NFRA.

78. Section 144, Explanation ii, Government of India, Companies Act.

79. Section 140, Explanation II, Government of India, Companies Act.

80. Sections 21A and 21B, Government of India, Chartered Accountants Act.

81. Section 132(4)(c), Government of India, Companies Act.

82. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 7.

83. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 7.

84. Securities and Exchange Board of India, Report of the Committee on Corporate Governance, pp. 83-84. Pursuant to a recent amendment in 2018, a listed company needs to disclose total fees for all services paid by the listed entity and its subsidiaries, on a consolidated basis, to the statutory auditor and all entities in the network firm/network entity of which the statutory auditor is a part. The amendment shall be applicable in respect of the annual report to be filed for the year 2018- 19 onwards. Securities and Exchange Board of India, Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) (Amendment) Regulations, 2018, Clause (10) of Part C of Schedule V.

85. Securities and Exchange Board of India, In respect of Price WaterHouse Co and Others.

86.Supreme Court of India, S. Sukumar v. The Secretary, ICAI and Others.

87. The proposed regulation further provides that action shall be taken by SEBI against the fiduciary incase of any violation of the obligations under the regulations. Securities and Exchange Board of India, Consultative Paper on Proposed SEBI (Fiduciaries in the Securities Market) (Amendment) Regulations; Recently, in August 2018, SEBI issued Report of Committee on Fair Market Conduct. The committee has recommended a separate code of conduct to be maintained by designated intermediaries, which includes auditors, dealing with price sensitive information of listed entities. Securities and Exchange Board of India, Report of Committee on Fair Market Conduct, 78 and 89.

88. In March 2018, RBI made joint audit compulsory in an Indian investee company, if the foreign investor specifies a particular firm having international affiliation to be appointed as auditor Reserve Bank of India, Transfer or Issue of Security by a Person Resident outside India) (Amendment) Regulations, 2018.

89. Reserve Bank of India, Enforcement framework for statutory auditors of commercial banks.

90. Ministry of Corporate Affairs, NFRA Chairperson and Members Appointment Rules.

91. Times of India, MCA writes to auditors on exits, 15 cases under lens.

1. Healy, “2015 Norma Parker Address: Being a Selfregulating Profession in the 21st Century: Problems and Prospects”, p. 2.

2. Securities Commissions, Model for Effective Regulation, p. 3.

3. Vass and Bartle, Self Regulation and the Regulatory State – A Survey of Policy and Practice, p. 37.

4. International Federation of Accountants, Regulation of the Accountancy Profession, p. 6.

5. Financial Reporting Council, Guidelines on Enforcement Measures against Recognised Supervisory Bodies and Recognised Qualifying Bodies, pp. 5-6.

6. Humphrey, Loft, and Margaret, “The global audit profession and the international financial architecture: Understanding regulatory relationships at a time of financial crisis”.

7. Lohlein, “Guarding the Guardians Essays on Audit Regulation”, p. 4.

8. Adams, “Professional Self-Regulation and the Public Interest in Canada”.

9. Cooper and Robson, “Accounting, Professions and Regulation: Locating the Sites of Professionalization”, p. 420.

10. DeMarzo, Fishman, and Hagerty, “Self-Regulation and Government Oversight”, p. 688.

11. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 48-52.

12. Standing Committee on Finance, Standing Committee on Finance 21st Report on The Companies Bill, 2009, paras 34-37.

13. Companies Law Committee, Report of the Company Law Committee, para 9.9.

14. Rajya Sabha, Delay in Constitution of NFRA.

15. The stated thresholds are yet to be notified by the government. Government of India, Cabinet approves Establishment of National Financial Reporting Authority.

16. Section 132(4), Government of India, Companies Act.

17. Standing Committee on Finance, Standing Committee on Finance 21st Report on The Companies Bill, 2009, para 9.23.

18. Reserve Bank of India, Enforcement framework for statutory auditors of commercial banks.

19. Securities and Exchange Board of India, Consultative Paper on Proposed SEBI (Fiduciaries in the Securities Market) (Amendment) Regulations.

20. DeMarzo, Fishman, and Hagerty, “Self-Regulation and Government Oversight”.

21. Simnett and Smith, “Public oversight: an international approach to auditing”, p. 47.

22. Section 104(g), United States of America, Sarbanes Oxley Act.

23. PCAOB, Report on 2017 Inspection of V. P. Thacker& Co., Chartered Accountants.

24. Financial Reporting Council, Deloitte LLP Audit Inspection.

25. Section 1224A, United Kingdom, Companies Act.

26. Kay et al., “Regulatory Reform in Britain”, p. 310.

27. RSB supervises certain aspects of audit profession, whereas RQB offers qualification and conducts examination.

28. Schedule 10, United Kingdom, Companies Act.

29. Schedule 11, United Kingdom, Companies Act.

30. Financial Reporting Council, Delegation Agreement.

31. Financial Reporting Council, Guidelines on Enforcement Measures against Recognised Supervisory Bodies and Recognised Qualifying Bodies, pp. 5-6.

32. Chapter III, Government of India, The Insolvency and Bankruptcy Code.

33. Section 201, Government of India, The Insolvency and Bankruptcy Code.

34. Sections 4.4.3 and 4.4.4, Government of India, The report of the Bankruptcy Law Reforms Committee.

35. The term ‘network’ has been defined by ICAI as ‘a larger structure: (a) that is aimed at co-operation; and (b) that is clearly aimed at profit or cost sharing or shares common ownership, control or management, common quality control policies and procedures, common business strategy, the use of a common brand name, or a significant part of professional resources’. See clause 2(g), Institute of Chartered Accountants of India, Revised Guidelines of Network; this definition is broadly aligned with the definition of ‘network’ in EU. See Article 2(7), European Parliament, DIRECTIVE 2006/43/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/ 660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC.

36. EY, Legal Statement; PWC, How are we structured?; Delloite, About Delloite.

37. KPMG, Structure.

38. Buxbaum, “The Viability of Enterprise Jurisdiction: A Case Study of the Big Four Ac-counting Firms”, p. 1791.

39. Buxbaum, “The Viability of Enterprise Jurisdiction: A Case Study of the Big Four Ac-counting Firms”, p. 1791.

40. Regulation 190, The Institute of Chartered Accountants of India, Chartered Accountants Regulations.

41. Pursuant to global reorganisation in Price Waterhouse and Deloitte, the name of their respective networks changed to PricewaterhouseCoopers and Deloitte Touche Tohmatsu. However, since this re-organisation took place after 1988, the Indian audit firms continue to operate under the old firm names.

42. Guideline 6 Institute of Chartered Accountants of India, Revised Guidelines of Network.

43. Guideline 7 Institute of Chartered Accountants of India, Revised Guidelines of Network.

44. Guideline 7, Institute of Chartered Accountants of India, Revised Guidelines of Network.

45. Guideline 7, Institute of Chartered Accountants of India, Revised Guidelines of Network.

46. Guideline 7, Institute of Chartered Accountants of India, Revised Guidelines of Network.

47. Institute of Chartered Acccountants of India, Expert Group Report, paras 4.6, 6.4.

48. Clause 2(g), Institute of Chartered Accountants of India, Revised Guidelines of Network.

49. Representation to this effect was made before the COE by S R Batliboi.

50. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 7.

51. Regulation 190, The Institute of Chartered Accountants of India, Chartered Accountants Regulations.

52. Paragraph 1.4, Appendix I, Institute of Chartered Accountants of India, Revised Guidelines of Network.

53. Clause 2(g) read with clause 5, Institute of Chartered Accountants of India, Revised Guidelines of Network.

54. Financial Express Bureau, Kapadia, Perrera, Makhijani & Girish May Help KPMG Beat ICAI Rules.

55. The CUE learned about the outcome of this application based on inputs from the stake-holders.

56. Jacob, Desai, and Agarwalla, “Are Big 4 Audit Fee Premiums Always Related to Superior Audit Quality? Evidence from India’s Unique Audit Market”.

57. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 15.

58. Securities and Exchange Commission, In the Matter of BDO China Dahua CPA Co. Ltd

59. Such firms have to register with ICAI under Regulation 190 read with Form 18, The Institute of Chartered Accountants of India, Chartered Accountants Regulations.

60. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 7.

61. Expert Group, Report of MCA’s Expert Group on Issues Related to Audit Firms, p. 13.

62. Section 250, Accounting Professional & Ethical Standards Board Limited, APES 110 Code of Ethics for Professional Accountants.

63. Section 1.600, Amercian Institute of Certified Public Accountants, AICPA Code of Profes-sional Conduct.

64. Chung and Sanjay Kallapur, “Client Importance, Nonaudit Services, and Abnormal Accru-als”, p. 948.

65. See, 12 CFR 621.31

66. Article 5, European Parliament and the Council, Regulation (EU) No 537/2014 Of the European Parliament and of the Council.

67. European Commission, Reform of the EU Statutory Audit Market – Frequently Asked Questions.

68. Auditing Practices Board, APB Ethical Standard 5, p. 1; Accounting Professional & Ethical Standards Board Limited, APES 110 Code of Ethics for Professional Accountants, p. 41.

69. Ghosh, S. Kallapur, and Moon, “Audit and non-audit fees and capital market perceptions of auditor independence”.

70. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, pp. 40-41.

71. Section 144, Government of India, Companies Act.

72. Section 144, Explanation(ii) Government of India, Companies Act.

73. Institute of Chartered Accountants of India, Notification No. 1-CA (7)/60/2002, para 3.

74. The amendment shall be applicable in respect of the annual report to be filed for the year 2018-19 onwards. Securities and Exchange Board of India, Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) (Amendment) Regulations, 2018, Clause (10) of Part C of Schedule V.

75. The thresholds are yet to be notified by the government. Government of India, Cabinet approves Establishment of National Financial Reporting Authority.

76. Section 144(1), Government of India, Companies Act.

77. Section 201, United States of America, Sarbanes Oxley Act.

78. Section C.3.2 and 3.8 Audit Committee and Auditors, Financial Reporting Council, The UK Corporate Governance Code.

79. Mahanta, Big four accounting firms PwC, Deloitte, KPMG, E&Yback in consulting business.

80. Ernst & Young, EYMember Firms and Affiliates; PricewaterhouseCoopers, List of active client facing entities within the PwC network.

81. Ernst & Young, EYMember Firms and Affiliates; PricewaterhouseCoopers, List of active client facing entities within the PwC network.

82. Laux and Newman, “Auditor Liability and Client Acceptance Decisions”.

83. Laux and Newman, “Auditor Liability and Client Acceptance Decisions”.

84. Controller General of Accounts, List of Major and Minor Heads of Account of Union and States, p. 102.

85. The jurisdiction of NFRA covers auditors of listed companies and public companies beyond a certain threshold as prescribed by the government.

86. European Parliament and the Council, Regulation (EU) No 537/2014 Of the European Parliament and of the Council, para 17.

87. Similar disclosure requirements exist in European Union. See Article 13 European Parliament and the Council, Regulation (EU) No 537/2014 Of the European Parliament and of the Council.

88. Institute of Chartered Acccountants of India, Study Group Report, (ii), 27.

89. Section 141(1) Government of India, Companies Act.

90. section 44 read with section 288 Government of India, Income Tax Act.

91. ICAI, MoU/MRA/Joint Declarations signed with Foreign Bodies.

92. High Level Committee on Corporate Audit and Governance, Report on Corporate Audit and Governance, p. 92.

93. Section 2(2), Government of India, Chartered Accountants Act.

94. Regulation 53A(1)(a)-(e), The Institute of Chartered Accountants of India, Chartered Accountants Regulations.

95. Mohan, A., Big 4 firms face charges of unauthorized practice of law.

96. Supreme Court of India, Bar Council of India v. A.K. Balaji and Ors. paras 7-8.

97. Vyas, M., Turf War: Law firms take on Big 4 – EY, KPMG, PwC& Deloitte expansion.

98. Legal Services Board, Evaluation: ABS and investment in legal services 2011/12-2016/17 – Main report, p. 12.

99. Legal Services Board, Evaluation: ABS and investment in legal services 2011/12-2016/17 – Main report, pp. 14-15.

100. Government of India, Consolidated FDI Policy, para 3.1.1.

101. Regulation 5(6), Reserve Bank of India, Foreign Exchange Management (Transfer or Issue of Security by a person resident outside India) Regulations.

102. Submission by Price Waterhouse Chartered Accountants LLP, dated August 2, 2018.

103. RBI’s email to the COE dated October 15, 2018.

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