INTRODUCTION
An Agency relationship comes into existence when a principal engages an individual as their agent to perform a service on their behalf and such performance is contingent upon the delegation of certain authority to such an agent. While such delegation of responsibility and the resultant division of labour translates in the promotion of an efficient management practice, such delegation is only successful if the principal trusts the agent enough to act in their best interests.
Now, a simple agency model would suggest that as a result of information asymmetries between the principal and agent and differing motives, principals lack reasons to trust that their agents are in fact, working in their best interest and in order to resolve such concerns, certain mechanisms would be put in place to align the interests of agents with that of the principal, thereby reducing the scope for information asymmetries and opportunistic behaviour.[1] This is where Corporate Governance mechanism step in.
The scope and ambit of Corporate Governance is dynamic and the politics of it range from promoter group ideologies, government regulations, stakeholder interests, volatility of market, other interest groups etc. Primarily, the aim of Corporate Governance framework is ‘good governance’ i.e. it aims to improve the company’s regulation mechanisms, its efficiency and its partake in social responsibility.[2] The scheme of Corporate Governance is such that it aims to alleviate the Agency Problem as discussed above and restrain the major stakeholder from furthering their own personal interests at the cost of shareholders interest.[3] Studies conducted in the filed show that there is a link between Selling, General and Administrative Costs (SG&A) which forms a huge chunk of Business costs and Agency problems.[4] If the scheme of Corporate Governance is strong then there is a positive impact in mitigating the effect of Agency problem on SG&A costs.[5]
The three generic Agency Problems as listed by Kraakman, Hansmann and Armour [6] briefly are:
1. Conflict between Shareholder (SH) and the Managers (BoD)
2. Conflict between Minority and Majority SH i.e. Controlling SH groupand non-controlling SH group.
3. Conflict between Shareholders and Stakeholders.
This sets the background against which we discuss the impact of good Auditing standards on Agency Problems. It is clear from the above discussion that Agency Problem(s) can prove to be highly problematic for the future of any business and it is imperative that steps are taken to ensure good health of the Company.
Auditing refers to an investigative, attestation, and reporting process that pertains to detecting wrongdoings by the management of the company.[7] Audits helps not just in enhancing economic viability of the Company but also plays an important role in the public interest and trust factor in the company.[8] In the Indian Context auditing plays an extremely important role owing to the many family run businesses and companies where chances of the strong promoter group placing their own interest before the interests of the remaining SH are very high. A check on the Financial Statements of the company by external auditors becomes extremely important so as to ensure there is no manipulation of data and accounts.
This paper uses results of studies conducted by scholars and other groups as secondary sources to substantiate the arguments put forth.
1. Auditing and the Agency Problem in India
The auditors play a very important role in overseeing the company’s financial matters. As per S. 141 of the Companies Act, 2013 (‘Act’) only chartered accountants can be auditors. S. 143 provides that the auditor of a company shall have access to the books of accounts of the company at all times. S. 139 (2) read with Rule 3 of the Companies (Audit and Auditors) Rules, 2014 (‘Rules’) provide for a very detailed regulation regarding the appointment of auditors in aspects of qualification and duration of holing office as an auditor.
This seems to indicate that the legislation has devoted a great deal of thought with regards to auditors. However, these sections and rules did not exist in the current format in the 1956 Act and were later incorporated after a series of scams that shook the economy of the country, the most important of them being the Satyam case in India and the ENRON case of the USA.
1.1 The ENRON Conundrum
A look at the ENRON case from the lens of analyzing the role of auditors suggests that investors including financial institutions could have been misled by the projection of the company’s net income by the Audit firm- Arthur Anderson. Its losses and liabilities were far larger than that were reported.[9] The lack of independence of the audit firm played a big role in carrying forward the manipulation of financial statements. There were personal relations between the Company and the Auditors in so much so that they were paid a huge fee with regards to their non-audit services. An interesting point is that this scandal happened despite there being accounting and auditing standards in place in the States.
This case proves that mere presence of legal framework of accounting and auditing standards is not enough if the auditors are not completely independent of the company being evaluated.
1.2 The Satyam Scandal
Satyam Computer Services founded by B. Ramalinga Raju and it caused a great deal of hue and cry after the chairman Mr. Raju in a letter confessed to manipulating the Company’s accounts by an amount close to $1.47 billion. The auditor firm- Pricewaterhouse Coopers (PwC) and the BoD allegedly knew nothing of the scam. This points to the glaring fact that the PwC intentionally did not abide by the accounting standard and failed to properly fulfil its duties as auditor. However, CBI investigations in 2018 found PwC guilty of conspiracy with the accused as they were not only paid more than any auditing firm during that time but also portrayed discrepancies in the treatment of Satyam; where it relied on the documents provided by the accused himself rather than doing any independent investigation and other companies it was auditing at that time.[10]
This case lays down the need of strict protocols that need to be followed by the Auditors while discharging their duties.
2. Legal Framework of Roles and Duties of Auditors.
2.1 Roles and Duties of Auditors
Auditors owe a duty of care to the Company whose audit they perform.[11] The qualification and experience of the auditors are set out in great detail in The Companies (Audit and Auditors) Rules, 2014. Similarly, disqualifications are also set down in the Act under S. 141(3) read with Rule 10 of the Rules. They provide for detailed instruction and gave gone so far as to lay down that a person whose relative or partner has any vested interest in the Company shall not be eligible to audit. The independence of the auditors is ensured under the provisions of S. 144 of the Act which prohibits the External Auditor from providing services either directly or indirectly, such as internal audit, investment advisory services, management services, outsourced financial services etc. This seems to emphasize the point that the ENRON Scam drove home the point the point that the possibility of the auditors and the management being in bed together is high and if independence is not insured then chances of fraud are very high.
Auditors are required to prepare a Report of their findings after examining the financial statements and other documents which is to be laid down in the general meeting of the Company. The provisions for this are provided in S.143of the Act read with Rule 11 of the Rules. Another highly debated provision is perhaps the reporting of Fraud if any found by the auditors. Prior to the Amendment of S. 143 (12), the requirement was that every instance of Fraud so found must be reported to the Central Government however, this was considered to be too severe a step as this would require even minor violations to be reported.[12] The amendment now requires only significant amounts to be reported to the central government and the rest to be brought to the notice of the Board. This scheme even though it was harsh suggested that the legislators has taken strict note of the flailing of the auditors.
2.2 Audit Committee
The audit committee reports are considered as required compliances for listed companies as well as certain unlisted companies. S.177 (4) read with the provisions of the LODR Regulations[13] set out the role and terms of the Audit Committee. The functions of the Audit Committee include reviewing and monitoring auditors independence, appointment of auditors, approving RPTs, and other financial controls and risk management systems.[14]
The most important role however seems to be the establishment of Vigil Mechanisms or Whistleblower policies.[15]These mechanisms are put in place to enable directors and other employees to flag suspicions of fraud and other violations. The safety net of these mechanisms are realized by ensuring direct access to the chairperson of the Audit Committee who is an Independent Director[16] and other safeguards to ensure against victimization of the Complainant.[17]
3. Analysis
The trick to address the Agency Problems lies in strengthening the auditor roles as auditing provides for a foolproof way of determining the “empire building”[18] mindset of managers which means that it checks against KMPs and Directors using the Company to forward their own personal goals and greed. It not only provides for a checks but also enables the BoD to take necessary steps to ensure good health of the Company. It addresses the overall economic growth of the Company by ensuring that there are no frauds being committed by the Promoter group just to portray a good image of the company which means that the share value of the company would be high much like what happened in Satyam case. The current regulatory framework has imbibed the independence of statutory auditors in great detail unlike that of the 1956 Act which was silent on Auditors Roles and Duties.
4. Trisure India Ltd. v. A.F. Ferguson
The auditor has a fiduciary relationship vis-à-vis the shareholders of the company[19], therefore they have a responsibility to ensure that it conducts its investigations and issues reports with utmost care and regard. This case saw the Court imparting a very cautious approach to auditors liability.[20] Statutory auditors independence is greatly debated by corporate executives and accountants. While corporate executives have often questioned the negligence of these auditors, professional accountants oppose this view and emphasize on the interference of the executives in the functioning of the auditors.[21] In a study conducted by IIM-Ahmedabad, it was noted that a significant number of CAs, Corporate Executives and Academicians believe that long standing relationship between Statutory Auditors and Client (more than 3.5 on a scale of 5) as well as Close relationship between Statutory Auditor and Management (more than 4 on a scale of 5) playa a huge role in determining the Independence of Auditors.[22]
The Court in this case while determining the above two variables in this case opined that fraud committed by the Company involved not just the top management but almost every department including Sales, Marketing, Security etc.. The fact in issue was that the Company which was a healthy company to begin with showed a steep increase in their profits which led to an over-subscription of their shares in the public issue. There was also an involvement of a whistleblower which led to usurping of the manipulation done by the staff of the Company to project such high profits. Interestingly, the Company on being exposed actually blamed the Auditors for not having done their job well enough and having missed the discrepancies in the profit margins.
The Court while deciding on whether or not the Auditors had done their duties to the nest of their abilities also laid down the roles and duties of an Auditor. The Court while citing several International guidelines and publications set out that the main objective of an Audit is to ascertain that the Financial Report of the fairly represents the actual financial position of the company.[23] The duty of the auditor does not in any way absolve the management of its own responsibilities and duties. While the Auditor expresses their opinion on the Financial statements, it is the task of the Management to prepare them. The role of the Auditor requires them to procure knowledge of their client’s accounts, and the knowledge of the internal controls in place however he is not to delve into the mechanism behind such internal control, that is solely the responsibility of the Management. [24] The next requirement of the Auditor is the Selective verification where certain transactions are selected for verification. The test for negligence of the Auditor is that whether the Auditor had reasons enough after employing his mind to ascertain that he could rely on the internal control in place by the management.[25]
The role of the Auditor is not to play detective and look for clues for fraud, he is liable to verify the Financial statements with other receipts of transactions but if there is no ground for suspicion, he cannot be expected to test the veracity of the receipts itself. The test for negligence does not demand the highest skill in that field but is in fact from the perspective of the prudent reasonable man.
The Court found that since the fraud being committed was so deeply entrenched that even the Security register was tampered with clearly indicates a mishap on the part of the management and since all these receipts added up perfectly, there was no ground for suspicion on which the Auditor should have acted.
5. CONCLUSION
India has come a along way since Satyam scandal, when it had almost no guidelines for Auditors, still there is a long way to go. While the Act has managed to incorporate the essence of Auditor’s Duties, to think it is foolproof would be a mistake. An auditor acts as an agent of the shareholders. He is expected to safeguard their interests.[26] If this has to be dissected we would ultimately arrive at the conclusion that although an auditor is an agent of the shareholders and according to the law of agency ‘the knowledge of the agent is the knowledge of the principal’, the shareholders are not bound for any information which the auditor might have acquired during the course of audit if he had not communicated it to the shareholders.[27] This can then mean that Minority shareholders will not be privy to the mishaps that the Company is engaged in especially if the independence of Auditors is compromised. Legislators moving forward should think about how to fill this void before another massive scandal hits the economy in the face.
[1] Agency Theory and the Role of Audit, AUDIT QUALITY FORUM (2005).
[2] James McRitchie, Corporate Governance in India Corpgov.net/ (2015), https://www.corpgov.net/2015/05/corporate-governance-in-india/ (last visited Jun 10, 2020).
[3] Hai LU, Clara Xialoing Chen & Theodore Sougiannis, The agency problem, corporate governance, and the asymmetrical behavior of selling, general, and administrative costs , 29 Contemporary Accounting Research (2011), https://ink.library.smu.edu.sg/soa_research/1576/.
[4] ibid.
[5] ibid.
[6] John Armour, Henry Hansmann & Reiner Kraakman, Agency Problems, Legal Strategies, and Enforcement , in The Anatomy of Corporate Law: A Comparative and Functional Approach, (2009), http://www.law.harvard.edu/programs/olin_center/papers/pdf/Kraakman_644.pdf.
[7] Yogesh Patel, A Review on Role of Auditor in Corporate Governance – The Auditor’s Perspective, 4 International Journal of Management & Business Studies (2014), http://www.ijmbs.com/Vol4.4/vol4.4/4-CA-Yogesh-Patel.pdf.
[8] Agency theory and the role of audit, ICAEW.COM, https://www.icaew.com/-/media/corporate/files/technical/audit-and-assurance/audit-quality/audit-quality-forum-fundamentals/fundamentals-agency-theory-and-the-role-of-audit.ashx.
[9] Amrita Mitra, Role of Auditors in Corporate Governance in the Light of Satyam Scam, (2012), https://ssrn.com/abstract=2128528 (last visited Jun 10, 2020).
[10] Sukumar, Auditors in on Satyam fraud: CBI Livemint (2009), https://www.livemint.com/Home-Page/jS33BnPzXSMnwbx9cFtplN/Auditors-in-on-Satyam-fraud-CBI.html.
[11] Umakanth Varottil & Richa Naujoks, Corporate Governance in India: Law and Practice, in India: The Business Opportunity (Linda Spedding ed., ).
[12] ibid.
[13] LODR Regulations, reg. 18(3) read with sch. II, part C.
[14] ibid at 10.
[15] Companies Act, 2013, s. 177(9); LODR Regulations, reg. 22.
[16] LODR Regulations, reg. 18(1)(d).
[17] ibid at 10.
[18] ibid at 2.
[19] ibid at 8.
[20] ibid at 10.
[21] Mitrendu Narayan Roy & Siddhartha Sankar Saha, Statutory Auditors’ Independence in India: An Empirical Analysis from the Stakeholders’ Interest Perspective, 41 VIKALPA: The Journal for Decision Makers (2016), https://journals.sagepub.com/doi/pdf/10.1177/0256090915626791 (last visited Jun 10, 2020).
[22] ibid
[23] Trisure India Ltd. v. A.F. Ferguson [1987]61CompCas548(Bom) Para 24.
[24] ibid Para 29-30.
[25] ibid Para 40.
[26] Ruchika Jha, Auditor and its position under company law, Law Times Journal (2020), http://lawtimesjournal.in/auditor-and-its-position-under-company-law/ (last visited Sep 29, 2020).
[27] ibid
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