New Companies Act draft hits small auditors more

The new rules say auditors will have to take highly costly indemnity insurance against third-party liabilities, feasible only for large firms

Auditors have to be compulsorily changed by a company at the end of two five-year terms, say the new rules.

The five-year period for rotation in the case of an individual and 10-year period for a firm will be calculated retrospectively.

Auditors fear this will impact smaller firms and they will be forced to consolidate, as they will not be able to attract new talent for auditing. Says N Venkatram, managing partner, audit, Deloitte, Haskins & Sells: "The increased demands on the audit profession and the churn in audit clients that is mandated will cause hardship for a few years. The retrospective application of rotation rules would necessarily result in increased cost and hardship to both companies and clients, and have the unintended consequence of harming audit quality."

RULES UNPLEASANT
The Union government on Monday released draft norms for clauses of the new Companies Act that replaces a six decade-old legislation

The bones of contention

• Auditors will now have to face penalties ranging from Rs 25,000 to Rs 25 lakh for non-compliance on issues such as filing and reporting
• Concept of class-action lawsuit introduced. Shareholders and depositors can claim damages and compensation from auditors for negligence
• Auditors will not be able to provide allied services such as consultancy and management accounting systems to the companies they audit
• Rotation of auditors is now mandatory. Auditors fear this will increasingly see a shift towards bigger players
• A whistle-blower policy has been introduced where auditors will have to report any wrongdoings to the central government
• Number of audits per partner has been restricted to 20, which crimps the earnings potential of an auditor

How much it will cost

• Auditors will now have to take indemnity insurance that will increase their costs, to which only the big firms will be able to adjust
• Audit firms will have to increase the support staff to do a more rigorous checking of the accounts
• Auditors are more likely to become conservative and ask for more details of expenses and statements from managements

The new rules have given some breather in terms of reporting on fraud by auditors to the Union government. Auditors are required to report material fraud within 30 days to the government. Materiality shall mean frauds happening frequently or those where the amount involved or likely to be involved is not less than five per cent of net profit or two per cent of turnover of the company for the preceding financial year.

Says Harinderjit Singh, partner, Price Waterhouse: "A mere allegation or suspicion will now have to be reported to the government. Professional guidance will need to be given to auditors."

Also, the new Companies Act imposes severe penalties on auditors of companies for various issues such as non-filing of documents.

It has also introduced the concept of class-action lawsuits. For negligence in their duties, auditors are liable to pay damages to the company or any other person for losses arising from incorrect statements in the audit report.

Company auditors are clearly worried that this is going to impact the business of auditing for small and big firms.

Says Shailesh Haribhakti, chairman, DH Consultants: "It's going to be very difficult for the auditing profession to attract, retain and deploy new talent, as the risks have gone up tremendously. Auditing will become more time-consuming and the costs will go up."

Auditors fear the Act will also increase their workload considerably - they will have to go through a larger number of transactions and keep extensive details on many. Auditors also have to take indemnity insurance against third-party liabilities, likely to be highly expensive. Auditors fear only the larger firms will be able to afford higher insurance costs.

The Act also mandates that an audit firm and all its partners are jointly liable for any fraudulent action of even a single partner.

Earlier only the partner in question had to face the consequences of negligence; with this new rule, an entire firm of auditors might have to down shutters for the errors of one partner. Says Singh: "It was always the individual who was signing the accounts. Now, with the concept of an entire firm being held responsible, the existence of the firm itself can be in jeopardy, without the relevant due process being defined."

The auditor is now also required to report on whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls.

Says Venkatram: "It is necessary that the rules clearly lay down the processes that need to be followed by the management of companies to make this evaluation. Based on the US experience, this is likely to be an onerous responsibility on both management and auditors, which will be expensive to implement."