Auditors’ disqualification on account of business relationships: purport and scope

–  Neha Malu, Executive (corplaw@vinodkothari.com)

Background

Considering the key significance of auditors’ independence in ensuring the integrity of the statutory audit function, the Companies Act, 2013 (‘Act’) has prescribed several eligibility conditions, qualifications as well as disqualifications for their appointment. While there are several disqualifications under section 141, which includes indebtedness, provision of guarantee, conviction, etc. The existence of a “business relationship” between the auditor and auditee has also been stated as one of the prima facie disqualifying factors for a person to be appointed as an auditor in a company. It is significant to note that this disqualification was not there under the corresponding provisions of the Companies Act, 1956.

The relevant clause dealing with ‘business relationship’ is clause (e) of sub-section (3) of Section 141 of the Act. The clause (as reproduced below) has a wide coverage and includes all direct as well as indirect business relationships as under –

‘A person or a firm who, whether directly or indirectly, has business relationship with the company, or its subsidiary, or its holding or associate company or subsidiary of such holding company or associate company of such nature as may be prescribed shall not be eligible for appointment as an auditor of a company.’

Further, the meaning of the phrase ‘business relationship’ has been detailed out under sub-rule (4) of Rule 10 of the Companies (Audit and Auditors) Rules, 2014 (‘Rules’) which also carries certain carve-outs. In this article, we have tried to unbox the said carve-outs given for the existence of those business relationships which do and which do not lead to disqualifying the auditors from appointment.

Meaning of “business relationship”

As per the Black’s Law Dictionary[1], business relations in the context of limiting conflict of interest with clients, refers to the existence of connection that in the normal course of events might bring the personal interest of the auditor into conflict with the impartial performance of his official duties.

“Business relation” is a vast term which covers all the commercial transactions ranging from availing the cab services provided by the company to managing the wealth of the company by a portfolio manager. In this manner, business relations may actually cover almost all prospective individuals who might be proposed to be appointed as the auditor of a company.

As given under Rule 10(4) of the Rules, the term “business relationship” shall be construed as any transaction entered into for a commercial purpose, for the purpose of clause (e) of sub-section (3) of section 141of the Act.   

Genesis of disqualification on account of business relationship

In the historic Enron scandal that happened in the United States, it was demonstrated that the auditors were also acting as the consultant of the company. There were several malpractices which came to light and eventually Arthur Andersen voluntarily surrendered its licenses to practice as Certified Public Accountants in the United States.  To prevent such mishappening, the famous Sarbanes Oxley Act, 2002 was enacted. It mandated the audit committee to directly oversee the engagement of the company’s independent auditor, and the Securities and Exchange Commission (the Commission) Rules were designed to ensure that auditors are independent of their audit clients.

A lot of emphasis is given on the idea of independence of the auditor because the responsibility of the auditor is not limited to shareholders. Audit report being a public document is relied on by various stakeholders of the auditee, including financial institutions, government, prospective investors and the public at large.

Carve-outs to business relationship

Rule 10(4) of the Rules provides some specific carve-outs where the existence of a business relationship does not disqualify a person from acting as an auditor.  These include the following:

(i) commercial transactions which are in the nature of professional services permitted to be rendered by an auditor or audit firm under the Act and the Chartered Accountants Act, 1949 and the rules or the regulations made under those Acts;

(ii) commercial transactions which are in the ordinary course of business of the company at arm’s length price – like sale of products or services to the auditor, as customer, in the ordinary course of business, by companies engaged in the business of telecommunications, airlines, hospitals, hotels and such other similar businesses.’

Permitted professional services

A member of the Institute of Chartered Accountants of India while providing the audit services to the auditee may provide the permissible professional services which includes:

1. audit under any other statute;
2. certification work required to be done by the statutory auditors;
3. any representation before an authority;

Transactions in ordinary course of business at arm’s-length price

The law gives examples of certain business relationships existence of which does not disqualify the auditor per se. However, the same is allowed only if both the components are present, that is–

1. Ordinary course of business
2. Arm’s length basis

In addition to these components, each of the products/services which are enumerated in the Rules are those where the interface between the service provider and recipient is quite short-lived and is not likely to create any financial dependence or personal interest which affects the independence of the auditor.

For example, a hotel provides hospitality to thousands of guests, and the mere fact that the auditor has stayed in a hotel room will not affect his independence. Same holds true for services provided by telecom service providers or health care services provided by a hospital or an airline company providing transportation service to its auditor.

Note that each of these services are those which have a very high extent of customer granularity, and very little scope for building up of an interface, interest, mutual financial dependence or pecuniary stake which bears on the independence of the auditor.

The clause uses the term ‘other similar businesses’. This should be based on the principle of ejusdem generis and therefore, should demonstrate features similar to the services listed above. Some examples of the same may be –

• A bank providing banking services to its auditor and charging normal fees as charged from the other clients.
• An internet service provider providing internet services to the auditor.
• Railways providing transportation services to the auditor.

Transactions which would not qualify as permissible commercial transactions

Though independence is a state of mind, it is presumed to be affected in case of the existence of a business relationship. However, as provided in the Guidance Note on Independence of Auditors, for the public to have confidence in the quality of audit, the independence of the auditor should not just exist in fact but must also exist in appearance to those who rely on the audit report of the entity.

Let us take example of some services which involve regular interface and therefore, may affect auditor’s independence.

• A Portfolio Management Company managing the bulk of the investible funds of the auditor.
• Stock broker buying/selling shares on behalf of the auditor.
• Auditor having a fixed deposit of a big amount say Rs. 50 Lakh with the bank of which he is proposed the auditor.

In these examples, there is a different level of engagement between the auditor and the service provider. The auditor is someone who has to be almost “Sthitpragya” in the language of Gita, i.e., one who is not lured by the external materiality –

‘sthita-prajñasya kā bhāṣhā samādhi-sthasya keśhava sthita-dhīḥ kiṁ prabhāṣheta kim āsīta vrajeta kim’.[Chapter 2, verse 54]

With so much dependence for his financial transactions, can an auditor actually be independent of his client? A general presumption will lead us to answer the question in negative, even if the same is in ordinary course of business and at arm’s length terms.

Test of auditor’s independence in case of business relationship

There are various judicial precedents^[2] to refer to where the auditor was held guilty of professional misconduct because of having business relations with the auditee. In the matter of Sharadchandra M. Kulkarni vs. Mahen J. Dholam, the auditor of the company was held guilty of professional misconduct because besides acting as the Tax Auditor, he was also engaged in active business association with the company in the capacity of a director without taking the permission of the Council. Also, in the matter of Ashish S. Kulkarni vs. Mahen J. Dholam, the auditor of the company was held guilty of professional misconduct because he incorporated a company with the partners and other relatives of a firm and signed the MOA and AOA of the company as a subscriber and also signed the audited financial statements of the company on behalf of the directors of the company.

Further, para 520 of the ICAI Code of Ethics provides guidance on the existence of business relationships as follow –

1.Disqualification based on existence of business relationship:

• A close business relationship of the auditor or the immediate family member of the auditor with the auditee, its management may create a self-interest or intimidation threat.

2. Conditions essential for disqualification based on existence of business relations:

• Existence of close business relationship is considered as a criteria for disqualification of an auditor and for a business relationship to be considered as a close business relationship, there should be a material financial interest or the said business relations are significant to the client or its management.
• For determining material financial interest and significance of the business relationship, the combined net worth of the individual and the individual’s immediate family members shall be taken into account.

3. Common interests in closely-held entities:

• The auditor, any member of the audit team or the immediate relative of the auditor shall not have any business relationship in the nature of holding interest in the closely held entity.
• An immaterial or insignificant financial interest or a financial interest that does not give the holder the ability to control the entity shall not be considered as a disqualifying factor.

4. Relationship as a customer:

• The purchase of goods or services by the auditor from the auditee does not usually create a threat to the independence of the auditor if it is in the ordinary course of business and at arm’s length price.
• However, such transactions might be of such a nature and magnitude that they create a self-interest threat.

Therefore to mitigate the threats, the following actions are provided:

a) Eliminating or reducing the magnitude of the transaction.

b) Removing the individual from the audit team.

Some examples of Close business Relationships giving rise to conflict of interest as provided by the Ethical Standards Board of ICAI are:

1. Material financial interest in Joint venture
2. Arrangements to combine one or more services or products of the firm with one or more services or products of the assurance client and to market the package with reference to both parties.
3. Business relationships involving an interest held by the firm, a network firm or a member of the assurance team or their relative(s) in a closely held entity when the audit client or a director or officer of the audit client, or any group thereof, also has an interest in that entity,
4. The purchase of goods and services from an assurance client by the firm (or from a financial statement audit client by a network firm) or a member of the assurance team, etc

Concluding remarks

While independence is call on one’s conscience, but the Act/Rules provide a narrow carve out which cannot be extended to include any arms’ length relationship, but only such transactions that are similar to other specified transactions. If any arms’ length relation was excluded, then even a loan transaction on arms’ length terms will claim to be exempt from the disqualification. Increasing the independence of auditors is to contribute to improving the quality of the audit but independence being a state of mind is not necessarily affected by a fact of mere business relationship with the company at arm’s length price. But any direct contact with the auditor having a lot of financial dependence shall be considered as a disqualifying factor.

[1] Revised Fourth Edition; DR 5- 104

^[2] Refer ICAI Case Laws Referencer – https://resource.cdn.icai.org/59111esb48239.pdf

Our other articles related to auditors may be read here –

https://vinodkothari.com/2019/11/sebi-on-resignation-of-auditors/

https://vinodkothari.com/2021/06/rbi-guidelines-at-odds-with-the-companies-act-on-appointment-of-auditor/

https://vinodkothari.com/wp-content/uploads/2019/05/Concept-of-Retiring-Auditors-under-Act-2013.pdf