Six years on, NFRA remains key to restoring trust in financial reporting

Next week will mark six years since the National Financial Regulatory Authority (NFRA) was constituted — a long enough period for it to find its feet, but not sufficient for institutional sclerosis to set in.

But first, it is worth recalling the genesis of NFRA. It lay in the Satyam Computer Systems fraud — one of the biggest in India.  Satyam’s founder and chairman, B Ramalinga Raju, confessed to manipulating the company’s accounts over several years. He admitted to inflating the company’s cash and bank balances, understating liabilities, and overstating debtors’ positions. The loss of credibility in the audited financial statements and the resultant erosion of investor and stakeholder confidence, risked taking down not just Satyam but the entire IT sector. The 21st Standing Committee on Finance noted that in light of recent experiences with corporate misgovernance, the audit process and the functioning of auditors should be made more independent and effective. It recommended prescribing stringent joint and individual liability, as well as setting up an oversight body to set standards and supervise the quality of audits.  

The Companies Act, 2013, provided the regulatory framework for the NFRA, but the Union Cabinet approved the proposal for its establishment only in March 2018, with the NFRA coming into existence on October 1, 2018.  This delay was mainly on account of the Institute of Chartered Accountants of India (ICAI) unwilling to cede ground, as it was also formed through an Act of Parliament. The Supreme Court intervened, urging the government to “consider appropriate legislation and mechanisms for oversight of the auditing profession, similar to the Sarbanes-Oxley Act, 2002, and the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010, in the US.” It was only after this intervention that the NFRA was constituted in 2018.

The primary objective of the NFRA has been to strengthen the financial ecosystem and ensure the credibility of financial statements. It is tasked with regulating both listed and unlisted companies, and their audit. Consequently, it has focused on a variety of issues related to the quality of financial reporting and practices, as well as adherence to standards. So far, it has issued numerous orders, and some of its observations are listed below.

The NFRA observed that auditors often face challenges in adhering to prescribed accounting standards (Ind-AS), which has led to inaccurate or misleading financial statements. Another common issue is the failure to adequately test and report weaknesses in internal control systems, contributing to potential financial misstatements. Also, inadequate audit documentation is a persistent problem; the NFRA has frequently noted gaps such as missing work papers, insufficient evidence, and poor documentation for key judgments. Auditors are also expected to identify fraud risks, but the NFRA has highlighted instances where critical fraud indicators have been overlooked or ignored, and fraud risk was not effectively communicated.

Another area of concern is the improper use of external confirmations, where auditors either fail to obtain sufficient confirmations or inadequately follow up on responses. Weaknesses in audit planning and risk assessment further compromise the effectiveness of audits. Moreover, auditors often exhibit an overreliance on management representations without independent verification, failing to exercise the necessary professional scepticism.

The NFRA has also observed lapses in evaluating the going concern assumption, with auditors not properly assessing whether companies can continue their operations, leading to inadequate disclosures about financial uncertainties. Instances of unethical practices, such as conflicts of interest and a lack of auditor independence, have also been noted. Inaccurate or misleading audit opinions are another issue, where clean opinions were issued despite significant misstatements, or audit opinions were not modified in light of identified issues. Finally, auditors sometimes struggle with complex accounting areas, such as derivatives, fair value assessments, and multi-component revenue recognition, leading to further lapses in audit quality.

Each of these observations leads to loss of credibility, causes reputational damage, erodes investor confidence, and has legal repercussions.

What about the future? The NFRA has a busy agenda ahead. From continuing its work on audit quality to encouraging the use of technology and artificial intelligence in audits, as well as sustainability reporting and alignment with global standards, it has much to accomplish. It has begun engaging with a wider set of stakeholders, and accelerating this with a closer interaction with the audit committees will strengthen its understanding of issues and how companies are approaching these. Its regulatory architecture will need to include a settlement mechanism. And as the institution matures, the need for an appellate body needs to be debated.  Going ahead, only if the NFRA can build organisational credibility, will the ecosystem and public markets have confidence in the financial reports that are presented.

The NFRA’s establishment fits well into the shifting arc of governance. Expectations now extend beyond just the company; its entire leadership, particularly the board, including its independent directors, along with auditors and investors, have a role in ensuring that companies are doing the right thing. The NFRA’s role is critical to this shift.

The writer is with Institutional Investor Advisory Services India Ltd. The views are personal. X: @AmitTandon_in