Importance of Audit for the Smallest of Enterprises - Response to NFRA's Consultation Paper

Introduction

The importance of Audit of an organization is perhaps as same as what is oxygen for human being. It is a 360 degree review of all the organization working and to speculate whether the organization can expand or if there is some cost cutting to do.

Auditing should be viewed not only as a statutory requirement but as a value addition for any entity. An auditor has professional skepticism and an overall understanding of the business process and is therefore capable of identifying deficiencies and improving the same thereby creating value for the services rendered. The correct accounts can only show the correct position and profitability of a company, assessment of which is essential for survival and growth of any entity irrespective of its size and complexities and audit by an independent CA can meet this end. Besides Auditor’s knowledge and skepticism helps in detection of Fraud and misfeasance, detection of non-compliances with financial laws of the land, ensuring timely filing of statutory returns and forms and reporting departure if any. This protects the client from monitory losses, penalties and prosecutions. Hence, the scope of Audit function can only but increase and has a bright future, it is just onto us professionals to project it in a proper way.

The National Financial Reporting Authority which is an independent authority was proposed by section 132 of the Companies Act, 2013 for the establishment and enforcement of accounting and auditing standards and oversight of the work of auditors. Pursuant to it, the Government of India constituted the National Financial Reporting Authority (NFRA) on 01st October, 2018 vide MCA Gazette Notification No. 5099(E), with its head office at New Delhi. On 13^th November, 2018, vide Gazette Notification No. G.S.R. 1111(E), Ministry of Corporate Affairs issued National Financial Reporting Authority Rules, 2018 (NFRA Rules, 2018).

On 29th September 2021, NFRA has issued a Consultation Paper and has raised some very interesting questions. These questions have created sensation among the Audit community, especially the one which raises questions on audit of MSMCs that is Micro, Small and Medium Companies.

This article is an attempt to provide the readers with the overview of NFRA and the Consultation paper issued by it. Before proceeding to NFRA, it is pertinent to comprehend the section 132 of the Companies Act in some details.

What is Section 132 of the Companies Act, 2013?

Section 132 consists of 15 sub-sections pertaining to Constitution of National Financial Reporting Authority, its functions, its constitution, its powers and other regulatory matters. Of these Sections 6,7,8,& 9 which proposed constitution of an Appellate Authority were removed by the Companies (Amendment) Act,2017 effective from 9th February 2018. Initially, Sub Section (3) and (11), which deals with composition of NFRA were notified on 21st March 2018. Thereafter, while sub-sections (1) and (12) were notified on 1st October 2018, the sub-sections (2), (4), (5), (10), (13), (14) and (15) of section 132 of the Companies Act, 2018 were notified on 24th October 2018.

The NFRA Rules, 2018

The NFRA Rule, 2018 consists of 19 Rules and 2 forms. These rules are:

1. Short Title and Commencement
2. Definitions
3. Classes of companies and bodies corporate governed by the Authority
4. Functions and duties of the Authority
5. Annual return
6. Recommending accounting standards and auditing standards
7. Monitoring and enforcing compliance with accounting standards
8. Monitoring and enforcing compliance with auditing standards
9. Overseeing the quality of service and suggesting measures for improvement
10. Power to investigate
11. Disciplinary proceedings
12. Manner of enforcement of orders passed in disciplinary proceedings
13. Punishment in case of non-compliance
14. Role of chairperson and full-time members
15. Advisory committees, study groups and task force
16. Financial reporting advocacy and education
17. Confidentiality and security of information
18. Avoidance of conflict of interest
19. International associations and international assistance

Form 1 Form NFRA-1 speaks of information of Auditor of Body Corporate & Foreign Body Corporate only. It is to be filed by:

Initial or one time disclosure on the commencement of the Rules: Body corporate, excluding companies falling under the scope of NFRA Rules, 2018, within 30 days from the date of deployment of the form on the website;

Regular Disclosures on the appointment of the Auditors: Every corporate body governed by NFRA, other than companies, within 15 days of appointment of an auditor. The requirement to file NFRA 1 confused many, so NFRA released a FAQ to clarify the requirement.

Form-2 is to be filed by the Auditors of companies governed by NFRA Rules, 2018 by 30^th November every year

NFRA Background

Prior to constitution of NFRA, there was a similar body under section 210(A) of the Companies Act, 1956 called National Advisory Committee on Accounting Standards (NACASA) which came into existence from 1998. Its main objective was to advise the Central Government on the formulation and laying down of accounting policy and accounting standards for adoption by companies. in consultation of Institute of Chartered Accountants of India. However, prior to NFRA coming into existence, Institute of Chartered Accountants of India (ICAI), was the sole regulator of auditors and auditing firms in India.

Role of ICAI in regulating Accounting and Auditing Profession

As a statutory body regulating the profession of Chartered Accountancy in India, the ICAI has had a long and glorious history in its 71 years of existence as the second largest Institute in the world. As the premier accounting body, the ICAI has delivered to the world high class CA professionals apart from setting bench- marks in the quality of financial reporting not only in India but across the Globe. ICAI regulates its members and hence ensures the quality of audit profession in number of ways as discussed below:

Auditing & Assurance Standards Board

The Institute had, in the year 1977, constituted the Accounting Standards Board (ASB) to formulate the accounting standards to be used in the preparation and presentation of general-purpose financial statements. The Institute also constituted, in 1982, the Auditing Practices Committee {now known as the Auditing and Assurance Standards Board (AASB)}. To review the existing and emerging auditing practices worldwide and identify areas in which Standards on Quality Control, Engagement Standards and Statements on Auditing need to be developed. So far AASB has issued 45 standards which include: 1 Standards of Quality Control (SQC), 37 Standards on Auditing (SAs), 2 Standards on Review Engagements (SREs), 3 Standards on Assurance Engagements (SAEs) and 2 Standards on Related Services (SRSs). SQC1 extensively deals with Quality Control for Firms that Perform Audit and Reviews of Historical Financial Information, and other Assurance and Related Services Engagements thereby ensuring the quality in audit profession in India.

Ethical Standards Board

ICAI has established the Ethical Standards Board to function as standard setting body. The Ethical Standards Board develops and issues ethical standards and other pronouncements for chartered accountants. It works towards evolving a dynamic and contemporary Code of Ethics and ethical behavior for members while retaining the long cherished ideals of `excellence, independence, integrity’ as also to protect the dignity and interests of the members.

Financial Reporting Review Board

ICAI in July 2002, constituted the Financial Reporting Review Board (FRRB) to review the general purpose financial statements of certain enterprises and auditor’s report thereon with a view to determine, to the extent possible:

• Compliance with the generally accepted accounting principles in the preparation and presentation of financial statements;
• Compliance with the disclosure requirements prescribed by regulatory bodies, statutes and rules and regulations relevant to the enterprise; and
• Compliance with the reporting obligations of the auditor.

Such review is done either suo motto or on a reference made to it by any regulatory body like, Reserve Bank of India, Securities and Exchange Board of India, Insurance Regulatory and Development Authority, Ministry of Corporate Affairs, Election Commission of India etc. In cases where FRRB observes non-compliance which are not material non-compliances it would appropriately bring the non-compliance to the attention of the auditor. However, if non compliance is material it would refer the case to the Director (Discipline) of the ICAIfor initiating action against the auditor under the Chartered Accountants Act, 1949.

Peer Review Board

It is a board established by the Council of the ICAI in 2002, with main objective to ensure that in carrying out the assurance service assignments, the members of the Institute comply with Technical, Professional and Ethical Standards as applicable including other regulatory requirements thereto and have in place proper systems including documentation thereof, to amply demonstrate the quality of the assurance services.

Quality Review Board

Government of India has on 28th June, 2007, constituted a Quality Review Board (QRB) to:

• To make recommendations to the Council with regard to the quality of services provided by the members of Institute;
• To review the quality of services provided by the members of the Institute including audit services; and
• To guide the members of the Institute to improve the quality of services and adherence to the various statutory and other regulatory requirements.

However, with NFRA coming into existence, the role of QRB has been curtailed, in respect to companies covered under NFRA, and the issue of QRB reviewing will only arise in case a reference is so made to QRB by NFRA, and not otherwise. Accordingly, QRB would now be able to initiate reviews of quality of audit services provided by members of the Institute only in respect of entities other than those specified under Rule 3(1) of NFRA Rules, 2018, namely, private limited companies, unlisted public companies below the thresholds specified under Rule 3(1) of NFRA Rules, 2018 and other entities not specified under Rule 3(1) of NFRA Rules, 2018; and those referred to QRB by NFRA under Rule 9(4) of NFRA Rules, 2018.

Disciplinary Mechanism Of ICAI:  ICAI not only performs its statutory duties as a regulator of the profession of Chartered Accountancy in India by formulating Accounting Standards in keeping pace with changing economic-scenario but also has enforced the ethical values as enshrined in Code of Ethics and proactively taken action against its erring members, found guilty of professional misconduct through its well-defined disciplinary mechanism. Under the disciplinary mechanism, a mandatory duty has been cast upon the Disciplinary Directorate of the ICAI to look into any alleged lapses/irregularities committed by its members across the country so as to lay down a strong foundation of credibility to the future members joining the profession, which it does through Director (Discipline), Board of Discipline and Disciplinary Committee.

Taxation Audits Quality Review Board

To review any report prescribed under the Income-tax Act, 1961 and Rules framed there under and any report prescribed under the Indirect Tax Laws including Goods and Services Tax Law which are certified by a Chartered Accountant (tax auditor) in respect of certain enterprises with a view to determine, to the extent possible, compliance with the reporting requirements prescribed under the Income-tax Act, 1961 and Rules framed there under; compliance with the reporting requirements prescribed under the Indirect Tax Laws including Goods and Services Tax Law and compliance with the respective pronouncements, guidance notes of ICAI.

Then Why NFRA?

As stated above ICAI already has robust system in place to regulate audit profession in India. This is the reason people have debated the requirement to constitute another body to regulate audit of a class of company. This can well be apprehended by the fact that while most sections of the Companies Act, 2014 became operational in 2014, section 132 of the Companies Act became functional in October 2018 and that too partially.

The argument went in favour of creation of NFRA as most of the major economies of the world have independent audit regulators. Besides, unearthing of huge financial scams like Satyam, not only in India but across the globe, has highlighted the need to tighten the corporate governance and reporting requirements for the corporate entities. One of the most disastrous outcomes of scams has been the non-performing assets (NPA) situation in Indian Banks. Besides, inadequate and improper financial reporting has been facilitating the tax evasion. Citing above reasons NFRA was finally created by the Central Government.

Coverage of NFRA

The rules and regulation of NFRA does not cover every corporate entity. The classes of companies and bodies corporate and their auditors governed by NFRA have been specified in the Rule 3 of the NFRA Rule, 2018. These are:

• companies whose securities are listed on any stock exchange in India or outside India;
• unlisted public companies having paid-up capital of Rs. 500 crores or more
•  unlisted public companies having annual turnover of Rs. 1000 crores or more
• unlisted public companies having, in aggregate, outstanding loans, debentures and deposits of Rs. 500 crores as on the last date of immediately preceding financial year;
• insurance companies, banking companies, companies engaged in the generation or supply of electricity, companies governed by any special Act being in force
• any body corporate or company or person, or any class of bodies corporate or companies or persons, on a reference made to the Authority by the Central Government in public interest; or
• a body corporate incorporated or registered outside India, which is a subsidiary or associate company of any company or body corporate incorporated or registered in India as referred to above, if the income or networth of such subsidiary or associate company exceeds 20% of the consolidated income or consolidated networth of such company or the body corporate.

It is pertinent to note that an entity stated above shall continue to be governed by NFRA for a period of three years after it ceases to meet the criteria mentioned above. All entities under the purview of NFRA are required to inform it, within 15 days of appointment of Auditor in Form 1. Besides, Rule 3(2) required every existing body corporate other than a company covered above to inform the NFRA within thirty days of the commencement of the NFRA Rules, in Form NFRA-1, the particulars of the auditor as on the date of commencement of the rules.

It is interesting to note that though the Rule 5 of the NFRA Rules, 2018 requires every auditor covered under NFRA rules to file a return in Form -2 with the NFRA on or before 30^th April every year. However, by an amendment dated 5th September, 2019, the last date for filing NFRA- by auditors was changed to 30th November every year.

Role of NFRA

Section 132(2) prescribes the broad role the NFRA is expected to play which are as follows:

• make recommendations to the Central Government on the formulation and laying down of accounting and auditing policies and standards for adoption by companies or class of companies or their auditors, as the case may be;
• monitor and enforce the compliance with accounting standards and auditing standards;
• oversee the quality of service of the professions associated with ensuring compliance with such standards, and suggest measures required for improvement in quality of service and such other related matters as may be prescribed; and
• perform such other functions relating to above.

The Rule 4 of NFRA Rules 2018, details the functions NFRA is expected to perform. Accordingly, it shall protect the public interest and the interests of investors, creditors and others associated with the companies or bodies corporate governed by it by establishing high quality standards of accounting and auditing and exercising effective oversight of accounting functions performed by the companies and bodies corporate and auditing functions performed by auditor. In a more specific way NFRA performs following functions:

• maintain details of particulars of auditors appointed in the companies and bodies corporate covered by it
• recommend accounting standards and auditing standards for approval by the Central Government;
• monitor and enforce compliance with accounting standards and auditing standards;
• oversee the quality of service of the professions associated with ensuring compliance with such standards and suggest measures for improvement in the quality of service;
• promote awareness in relation to the compliance of accounting standards and auditing standards;
• co-operate with national and international organizations of independent audit regulators in establishing and overseeing adherence to accounting standards and auditing standards; and
• perform such other functions and duties as may be necessary or incidental to the aforesaid functions and duties.

Powers of NFRA

The NFRA shall have the following powers as per the section 132(4) of the Companies Act, 2013:

• To investigate the matters of professional or other misconduct committed by a prescribed class of CA firms or CAs. No other authority can initiate or continue proceedings where the NFRA has initiated an investigation. Such an investigation can be initiated either suo moto (by itself) or on a reference made by the Central Government.
• The same powers as a Civil Court in respect of a suit involving:
  • Discovery and production of books of account and other documents
  • Summoning and enforcing the attendance of of persons and examining under Oath
  • Inspection of any books, registers, and other documents of any person at any place
  • Issuing commissions for the examination of witnesses or documents
• Where professional or other misconduct is proved, it shall have the power to impose the penalty which may be as follows:
  • For individuals a fine between Rs. 1,00,000 to 5 times the fees received
  • For firms a fine Between Rs. 5,00,000 to 10 times the fees received
• Where professional or other misconduct is proved, it shall have the power to debar the member/firm from being appointed as an auditor or internal auditor or undertaking any audit in respect of financial statements or internal audit of the functions and activities of any company or performing any valuation services for a period which may be from 6 months to 10 years.

Thus, we see NFRA has extensive powers in relation to auditors of the Companies covered under the NFRA Rule 3.

Appeal Provision

The section 132(5) off the Companies Act, 2013 provides that any person who is not satisfied with the order of the NFRA can then make an appeal to the Appellate Authority.

NFRA Consultation Paper

NFRA has issued a Consultation Paper on 29th September 2021 to review the requirement of compulsory statutory audit and compliance with auditing standards for all companies irrespective of their size and/ or public interest, specially the ‘Micro, Small and Medium Companies (MSMCs)’ with net worth of less than Rupees 250 Crores. Stakeholders have been invited to submit their comments by 10/11/2021. After conducting a preliminary analysis on the key financial parameters of the companies registered in India, the NFRA has provided following observations:

• Dominance of private limited companies: As per NFRA’s report around 95% of companies incorporated in India are one-person or private company.
• High Non- Compliances among Companies: NFRA has pointed out that only 52.48% of the companies have done their annual filings with MCA and for FY 2018-19, even after two years which they attribute to lack of adequate accounting professionals with many of these companies.
• Dominance of MSMCs: Out of the total companies which have made filings, 99.41% have reported Net Worth below ₹ 250 Crores which are to be treated as MSMCs for the purpose of the consultation paper.
• Low Turnover Companies: Around 34.88% of companies have reported nil turnover and of rest nearly 61.22% have very low turnover i.e., below ₹ 50 Crores.
• Indebtedness: Nearly 45% of MMCs are debt free. Of the remaining companies around 5.68% have debt below Rs.25 crores.
• Ease of doing business: The regulations relating to financial reporting and auditing should not impose undue burdens and cost on the regulated entities, and the overall regulatory framework should be proportional to the size and type of the entities that are subject to such regulations.
• Low Audit Fees: The fees paid to auditors by a large majority of Micro, Small and Medium Companies (MSMCs) are way below what an audit, when performed in compliance with the letter and spirit of the Standards of Auditing, would require. Around 41.41% of the companies have reported Audit Fee below Rs. 25000 and over 40000 companies have reported audit fee below Rs. 5000. NFRA withhypothetical example, has worked out that a reasonably good quality audit, for an MSMC, with Turnover below 50 Crores would cost in the range of 1.50 lakhs to Rs. 8.43 lakhs.
• Limited Users of Financial Statements of MSMCs: As per NFRA a large majority of Companies has very low or NIL Indebtedness, which indicates low risk to the larger public interest and therefore very limited users of financial statements. Here it is important to note Rs.25 crores cannot be regarded a small in country like India, and secondly, lenders are not the only users of financial statements.
• Auditing Threshold set by Tax authorities: As per NFRA Tax audit has been dispensed with for businesses with turnover of up to Rs 10 crores, provided not more than 5 % of the total transactions are in cash. GST Audit has also been completely done away with. It is to be noted these threshold are there probably because Tax Department relies on statutory audit for corporate entities and in case of other entities too they have already set a minimum presumptive tax limit to avail these exemptions.
• Global Precedence: NFRA has at length discussed how various countries either never required or has done away with audit for smaller companies. It covered the study of European Union, UK, Singapore, Australia, USA and Japan. Most countries give exemption from Audit to small companies where public is in not substantially interested based on meeting of the three criteria viz. Turnover, Net worth & Number of Employees. USA accepts financial statements that are certified by the management in case of small companies, in case they are not certified by a CPA. Japan has audit requirement only for specified large companies.

The Questions raised by NFRA

Question No. 1 - Do you think that Micro, Small and Medium Companies (MSMCs) depending upon some criteria and threshold should be exempted from the mandatory statutory audit under Companies Act, 2013? If not, why not and if yes, what would be the criteria and thresholds for exemption?

NFRA consultation paper discusses the audit exemption requirement in 5 countries and European Union. The countries chosen have robust legislative and governance mechanism in place. The NFRA consultation paper should be viewed as an opportunity for the audit professional to talk to various chambers of commerce and let the world and stake auditor know about of the importance of auditing function performed by the Auditor. There is a difference between the audit and investigation which happens only when there is a strong possibility some fraud or misrepresentation. However, the auditor’s role is that of a watch dog and not of a blood hound. The paper gives an opportunity to look at the services rendered by professional and enhance in a way such that the value added by audit function is many times the cost incurred by the client. An auditor who by nature of his job acquires an in depth knowledge of business processes like purchase, sales, marketing, human resource management, regulatory compliances, risk management, etc can benefit the client by identifying the loop holes in these areas and advising the best practices. In this way, auditor’s role in the smallest of the companies is justified and is much over and above the cost incurred. The audit of financial statement is even more justified in smaller entities, as these entities are incapable of employing internal qualified staff for each function like Human resource management like PF and gratuity, Direct and Indirect Tax expert, Company Law Compliances, Accounting, etc. The auditor is often the only person who guides them through all these necessary compliances and also ensure that various stakeholder get the correct information regarding the financial position and profitability of the company.

Question No. 2- Do you think there is a requirement for a separate set of auditing standards for MSMCs as it exists for accounting standards? If no, why not and if yes, what should be the basis for the same?

The current auditing standards are in lines with international standards. However, looking at the number of small companies in India (over 13Lakh), it would not be a bad idea to simplify the standards for MSMCs.

Question No. 3 – The cost of conducting an audit as per the prescribed standards is an important input for the responses to Questions 1 and 2. Do you agree with the approach for estimating standard cost of audit computed by NFRA? If not, which areas/ assumptions need changes?

The cost charged by any professional increases with experience. This is because with experience one acquires professional skepticism. So it is unreasonable to compute cost of professional services. In fact the cost assessed is too low looking at the professional insight provided by a CA which is gained after year of hard work.

Question No. 4- Do you think the current exemption thresholds for CARO, ICFR and statutory audit applicability need to be standardized and made uniform? If no, why not and if yes, what would be the criteria and thresholds?

Companies (Auditors Report) Order, 2020 (CARO) is applicable for all statutory audits commencing on or after 1 April 2020 corresponding to the financial year 2019-20. The order is applicable to all companies which were covered by CARO 2016. Accordingly, the order applies to all the companies except the following companies specifically excluded from its purview:

• One person company, Banking companies, Insurance companies, Companies registered for charitable purposes and Small companies i.e. Companies with paid up capital less than/equal to Rs 50 lakh and with a last reported turnover which is less than/equal to Rs 2 crore.
• Besides, the following private companies are also exempt from the requirements of CARO, 2020: –
  • Whose gross receipts or revenue (including revenue from discontinuing operations) is less than or equal to Rs 10 crore in the financial year
  • Whose paid up share capital plus reserves is less than or equal to Rs 1 crore as on Balance Sheet date.
  • Is not a holding or subsidiary of a public company
  • Whose borrowings is less than or equal to Rs 1 crore.

Internal Control Financial Reporting (ICFR) is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. IFC/ICFR is applicable without any terms and conditions for listed companies and public unlisted companies. In the case of private companies, IFC/ICFR is applicable wherein Turnover is more than Rupees 50 crores or outstanding loan & borrowings from bank are more than Rupees 25 crores.

As discussed earlier, whether there is any statutory requirement or not audit is as important a function of any enterprise, irrespective of its scale and size, as keeping the financial records. The fact that other forms of audit like CARO and ICFR have limited applicability makes it even more important to retain statutory audit for all kind of enterprises.

Conclusion

10^th November, 2021 is the last date to comment on this consultation paper. Professional peers should grasp this opportunity to draw attention of regulators towards the importance of audit for smallest of entity in country like India. Every professional should submit their comment on the consultation paper in writing either by email at comments-tac.paper@nfra.gov.in or by post and be united in emphasizing the retention of audit requirement for the MSMCs.

I have a firm belief that the Consultation paper dated 29^th September 2021 of NFRA (National Financial Reporting Authority) is an opportunity to tell the world advantages of audit to even smallest enterprise.

I view the consultation paper as a chance to relook at our services, to enhance the quality and benefit of our services to stakeholder and overall society.