Looking to overhaul India’s far from perfect financial reporting scenario, the National Financial Reporting Authority (NFRA) has decided to engage directly with companies, particularly the chief financial officers (CFOs) and audit committees. Previously, NFRA solely focused on auditors in cases where it identified issues with financial statements. The authority is responsible for ensuring companies adhere to proper accounting standards and that audits are conducted effectively.
By engaging with both auditors and companies, the regulator aims to gather a broader perspective and ensure auditors do not solely dictate the narrative. If any lapses are found, NFRA will refer the matter to the appropriate regulator. Since the company is ultimately responsible for the accuracy of its financial statements, NFRA has encouraged directors to ask critical questions to understand the audit process and findings. The authority emphasises the importance of clear communication between auditors and companies, particularly audit committees and independent directors.
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State of financial reporting in India
NFRA has been advocating for financial reporting reforms and released its first set of audit firm inspection reports last year, highlighting areas for improvement in documentation, risk assessment, and auditor independence. In December 2023, NFRA released inspection reports for the Big Four firms, namely BSR & Co, Deloitte Haskins & Sells, SRBC & Co, and Price Waterhouse Chartered Accountants, followed by a report on Walker Chandiok & Co.
In the 24 observations published by NFRA, a quality inspection of the four major audit firms resulted in the identification of a key concern – a potential lack of integrity in audit documentation. Some audit software allowed modifications even after sign-off, raising questions about the authenticity of records. Additionally, the absence of proper documentation trails for changes and a lack of rationale for selecting specific audit areas for review were noted.
The monitoring body also found instances where firms failed to reassess audit risks as required by standards. For one firm, it was not ascertained that all members were independent of the audit, suggesting potential vulnerabilities in the auditing process and raising concerns about conflicts of interest or inadequate risk mitigation strategies. The inspected firms have acknowledged the observations and pledged to incorporate them in future audits.
The concerns identified by NFRA in its audit firm inspections resonate with similar issues highlighted globally. A 2023 report by the International Forum of Accountants (IFAC) found that audit quality remains a persistent concern, with a lack of transparency and insufficient communication between auditors and companies being key issues. This echoes NFRA’s focus on fostering clearer communication and collaboration between these stakeholders.
Furthermore, the IFAC report emphasises the need for robust audit documentation practices and stricter independence rules to mitigate potential conflicts of interest. These findings align with NFRA’s observations regarding the potential lack of integrity in audit documentation and concerns about potential independence issues identified in one of the inspected firms. Addressing these concerns is crucial for building trust in the financial reporting ecosystem, not just in India, but globally.
Lessons for NFRA from abroad
As NFRA continues its efforts to improve the Indian financial reporting landscape, it can draw valuable insights from successful initiatives implemented by other regulatory bodies worldwide. For instance, the Public Company Accounting Oversight Board (PCAOB) in the United States mandates annual inspections of audit firms for listed companies. Additionally, the European Union’s Audit Regulation (EU AR) emphasises robust audit firm governance, transparency, and auditor independence. By adopting similar practices and tailoring them to the Indian context, NFRA can strengthen its regulatory framework and contribute to a more reliable and transparent financial reporting environment.
NFRA will reinspect the “big four” firms this year and is expected to conduct more inspections beyond the “big four”. It will reassess internal changes and improvements following its recommendations. For the next batch of review, firms will be selected based on various parameters, including the extent and significance of the public interest, such as the number of companies audited by the firm.
The next round of inspection of the Big Five is slated for March, with a focus on potential conflicts of interest, particularly instances where related entities of these auditors perform non-audit services for the same companies being audited.
NFRA has been punishing errant auditors and companies with penalties and restrictions on accepting audits. The authority has also given suggestions on compliance with different auditing standards. However, it needs to remember that auditing errors can only be minimised and not totally eliminated.
Since accurate financial reporting is key to building trust in businesses and fostering a healthy investment climate, NFRA may consider a few moves to incentivise companies. One, audit fees could be raised, particularly for listed companies, allowing audit firms to invest in better technology, quality control processes, and improved documentation practices. Companies demonstrating strong adherence to regulations could be rewarded by NFRA, further incentivising responsible financial reporting.
NFRA must also consider publishing sample audit manuals with minimum documentation requirements. For mid-sized firms, this may be especially useful as they could use this document as a reference point for their audit documentation. This could be developed in collaboration with the Institute of Chartered Accountants of India (ICAI) to leverage the institute’s expertise in the matter. The auditor, auditee, and regulators must work together to create a better financial reporting scenario.