NFRA proposes copious financial information disclosures by auditors of large listed companies
An Annual Transparency Report to be published on the websites of the auditors
– Burhanuddin Kholiya and Payal Agarwal | corplaw@vinodkothari.com
In a major step to ensure transparency of audit and non-audit services, and internal protocols, quality checks, etc being maintained by auditors or large listed entities, the National Financial Reporting Authority (NFRA), vide a letter dated 16th January, 2023 (hereinafter referred to as “Proposal”), has proposed publication of an Annual Transparency Report (ATR) by the auditors of top 1000 listed companies. The ATR contains copious data, and interestingly, requires financial information about the audit firm, as well as its network entities. NFRA indicates that this proposal is in line with global practices, citing examples of regulations in the European Union (EU) and Australia.
The Proposal is said to be in terms of Rule 8(2) of the NFRA Rules, 2018 which empowers NFRA to require an auditor to report on its governance practices and internal processes designed to promote audit quality, protect its reputation and reduce risks including the risk of failure of the auditor and may take such action on the report as may be necessary, is proposed to be implemented for FY23 to begin with.
A quick snapshot of the same can be referred here.
Background of the Proposal
This proposal is based on the recommendations from the Committee of Experts (COE)[1] established in the year 2018 for addressing the issues raised by the Supreme Court of India in its judgment in S. Sukumar v. The Secretary, Institute of Chartered Accountants of India. The special leave petition filed before the Supreme Court of India pertained to the violation of law by the Multinational Accounting Firms (MAFs) operating in India, through the breach of the Code of Professional Conduct given under the Chartered Accountants Act, 1949. It was alleged, inter alia, that the MAFs were engaged in illegal operation of accounting, auditing, bookkeeping, and taxation services. Amongst the other directions issued by the Supreme Court, it also issued directions to the Union of India for the establishment of a committee for examining several issues raised therein, and recommend steps to appropriately discipline and regulate MAFs.
The COE recommended the introduction of ATR to enable NFRA to identify the instances of audit failure/ fraud caused due to faulty methodology followed by a particular network of which such an auditor is a part of, and impose a monetary penalty on the members of such network.
The concept of this report is not new: a similar requirement has been in existence in some European countries and countries like Australia. Rule 14 of the EU Regulation No 537/2014 on specific requirements regarding statutory audit of public-interest entities specifies the requirement of a detailed report for the oversight of statutory auditors and audit firms. Similarly, section 322B of Corporation Act 2001, Australia read with Schedule 7A thereto, also requires auditors to publish transparency reports. The main objective of this reform is to restore the confidence of investors in the statutory auditors and the audit firms carrying out the statutory audit of PIEs.
Applicability of ATR
The ATR is proposed to be made applicable on the statutory auditors (whether audit firm or individual auditor) of PIEs falling within the purview of NFRA. The requirement of ATR is proposed to be implemented in a phased manner, starting with the auditors performing audits of the top 1000 listed companies (by market capitalization ) for the financial year ending 31st March, 2023.
Meaning of Public Interest Entities (PIEs) falling within the purview of NFRA
While the term ‘Public Interest Entity’ is not specifically defined under the Indian statutes, a press release by PIB refers to the term to mean all the entities that are covered within the purview of NFRA. This includes all listed companies as well as large unlisted companies.
Rule 3 of NFRA Rules prescribes the following classes of companies and body corporates to be governed by NFRA:
- Companies whose securities are listed in India or outside India
- Unlisted public companies having:
- Paid-up capital of Rs. 500 Cr. or more; or
- Annual turnover of Rs. 1000 Cr. or more; or
- Outstanding loans, debentures, and deposits aggregating to Rs. 500 Cr. or more
as on 31st March of the immediately preceding financial year.
- Insurance companies, banking companies, companies engaged in the generation or supply of electricity, companies governed by any special Act, or body corporate to which the provisions of the Companies Act, 2013 apply in terms of section 1(4) of the Act.
- 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.
- A body corporate incorporated or registered outside India, which is a subsidiary or associate company of any entity covered in either of the aforesaid clauses, if the income or net worth of such subsidiary or associate company exceeds twenty percent. of the consolidated income or consolidated net worth of such entity covered under either of the aforesaid clauses.
Entities covered in the first phase of implementation
As discussed above, the ATR is currently proposed to be made applicable to the top 1000 listed entities on the basis of market capitalization.
Meaning of market capitalization
For the purpose of examining the applicability of the proposed ATR, the market capitalization will be based on the average market capitalization published by the Association of Mutual Funds (AMFI) for the six months period of July – December of the immediately preceding financial year[2].
The reading of the present Proposal indicates that for the ATR published for the FY 22-23, the market capitalization of the entities during the time period of June-December, 2021 (FY 21-22 being the preceding financial year) will be taken into account. The ATR is required to be published within 3 months from the end of the financial year to which it relates, and therefore, the ATR for FY 22-23 will be published during the FY 23-24. In such circumstances, while the facts and information provided in the ATR pertains to FY 22-23, the same will be in relation to the entities covered under the list of top 1000 for the FY 21-22, evidencing a gap of around 1.5 years between identification of an entity as top 1000 and reporting of the details in the ATR.
In such cases, it may further happen that while the auditor is the statutory auditor of the prescribed entity at the time of identification, the same does not remain an auditor of such entity at the time of reporting in ATR.
Therefore, in our view, the reference to “immediately preceding financial year” should not be taken to mean the financial year prior to the financial year for which reporting is being made, but may be construed as the financial year to which such reporting pertains. For example: For ATR prepared for FY 2022-2023, the average market cap for the six-month period ending on 31st December, 2022 should be taken since the reporting for the FY 2022-2023 will be made in FY 2023-24.
Further, it is to be noted that the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 also prescribes applicability of certain provisions on select listed entities based on market capitalization. For the purpose of applicability of such provisions, the market capitalization is checked as on 31st March of the financial year. NFRA may consider streamlining the Proposal with the timelines proposed under such regulations.
Whether one single ATR is required to be filed by the auditor or on a per-company basis?
The disclosure is required to be made on a per-auditor basis, and not per-company basis. This is evident from the various contents of the proposed ATR, as discussed below.
The entire requirement of publishing this ATR arises to avoid conflict of interest that the auditors may face as often firms forming part of the network of the audit firm engage in providing non-audit services to the auditee. This reporting is aimed at disclosing all such interests. Reference may also be taken from the COE’s recommendations wherein it is stated that “The law could impose various disclosure obligations on auditors. Such norms could help reveal the conflict of interest that the auditors may face, the sources of funds they receive, and the methodology behind their recommendations.”
The ATR aims at regulating the overall activities of the auditors, and therefore, the disclosures are also required to be made in respect of the auditor and not on a per-company basis.
Whether the requirement of ATR is one-time or a periodic exercise?
NFRA has recommended publication of ATR for every financial year till the auditor is assigned or engaged in the audit of PIEs. Financial year would mean the period ending on 31st March of every year.
Further, the same will be applicable only till the time the auditor is engaged as an auditor with a covered PIE. If the entity ceases to be a covered PIE or otherwise, if the auditor ceases to remain engaged with the covered PIEs, the requirement of publishing ATR will also cease to apply.
Who is required to approve ATR?
The Proposal specifies that ATR must be approved by the persons who approve the financial statements of the statutory auditor as per law. This would depend on the legal structure of the auditor.
For instance, where the audit firm is carrying its business in the form of an LLP, the financial statements of the said LLP, and therefore, the ATR, must be approved by the designated partners of the LLP. Similarly in case of a partnership firm, it is to be approved by the partners. In case of sole proprietorship, it is the proprietary of the concern who is required to approve the financials as well as the ATR.
Where is the ATR required to be published?
This ATR must be prepared and published on the website of the auditor within the period of three months from the end of each financial year commencing from the end of FY 2023. Further, the same is required to be filed with NFRA before it is published on its website.
It leaves certain questions unanswered. First, what if the auditor does not have any website? Can this Proposal be taken to attract a mandate on the auditors of the top 1000 listed entities to have a functional website?
Further, if only one of the partners of an audit firm is appointed as auditor of a covered PIE, would that still attract the obligation for publication of ATR on the audit firm, or on the individual partner who is conducting the audit? This question may be answered in reference to the EU Regulations which provides that if an auditor is employed by an audit firm, then the obligation to upload the report shall be discharged by said audit firm.
Several practitioners having a functional website requires a registration process to be carried out by a person willing to access the information available on their website. We understand that such registration requirements may continue to apply, however, the purpose being transparency of information, the access to ATR should not be limited to specific users of information, on the basis of premium registration requirements.
Further, the Proposal is not clear on the duration for which this report should be available on the website. Unless an express requirement is put forward by the NFRA, it appears that this report shall continue to be available until the next report for the following financial year is uploaded.
Disclosures required under the report
The Proposal requires auditors to disclose information such as the structure of the audit firm, disclosure of details about the network of the audit firm, details about work alliances, collaboration etc. Further, the total turnover of the auditors as well as firms with the Network of such auditors is required to be disclosed, categorized into various services rendered by them as well as sources bifurcated as PIEs and entities other than PIEs.
The ATR proposes disclosure of the following –
General information about the auditor
This includes disclosure of the legal structure, ownership, management and governance structure of the auditor.
Details about the network
In case the auditor is a member of any network, whether in India or overseas, details of the same are required to be disclosed in the ATR. This includes disclosure of information such as –
- Description of the legal, operating structure and domicile of the Network
- Registration requirements/ oversight of any professional accountancy body or independent regulator on such Network
- Nature of the activities and services rendered by such Network
- Name, Domicile and legal and operating structure of the other Members of the Network operating in India and overseas and nature of their activities
- Total Income of the Network and the source of this income
In order to disclose the information as aforesaid, it is essential to understand the meaning of “Network” and the entities covered in the Network to which the auditor belongs. The term “Network” has been defined by the ICAI in the Guidelines for Networking of Indian CA firms, 2021 in the following manner –
“Network means a larger structure of a group of Indian CA Firms that have come together for mutual benefits by pooling resources, showcase their combined strength, and have uniform policies, technology and collaterals, and showcase themselves as one big unit.”
However, it has to be noted that the definition given by ICAI limits the network to the Indian CA firms, whereas, the Proposal of NFRA extends beyond only Indian CA firms, and covers the overseas network as well. Therefore, some clarity may be required from NFRA with respect to the scope and coverage of the entities within a network.
Details about the collaborations of the auditor
The auditor is required to disclose certain details about the Working Alliances, Collaborations, Licensing Arrangements, Knowledge/Resource Sharing Arrangements, if any, of the auditor with any third party or organization, in India or International. This includes information on –
- Name and domicile of the entity with whom the auditor has such arrangements
- Nature and details of such arrangements
The scope of this disclosure is wide enough to cover various entities related to the auditor in some way or the other, for example, for sharing knowledge, providing assistance, collaboration in working, providing technological support etc. Many audit firms enter into or collaborate with international entities such to share audit methodology, know-how etc. This clause in ATR would require the Indian auditor to disclose requisite information of all such collaborations/ alliances.
Description of the policies and procedures of the auditor
Various qualitative disclosures are sought with respect to the overall internal quality control of the auditor, monitoring and ensuring compliance with the independence of the auditors, acceptance and continuation of audit clients, audit methodology, operating effectiveness etc. It also requires details of the remuneration structure of the partners and senior staff, transaction pricing for services to/ from members in the Network etc. The reporting auditor is also required to disclose the date of the latest internal review along with deficiencies and remedial actions, as well as, date of latest review by NFRA.
While these mostly require qualitative commentary from the auditor, the same should also be supplemented with quantitative metrics, to the extent possible.
Details of the entities governed by NFRA and audited by the auditor and/ or other members of its Network, alliances or collaborations in India
This requires disclosure of all the entities covered within the purview of NFRA, irrespective of whether the same is covered within the list of top 1000 listed entities by way of market capitalization or not. Further, the scope of the disclosure is not limited to the entities audited by the auditor but also extends to the members of its Network, alliances, collaborations etc. This would require copious disclosures in the ATR and the reporting auditor may not have access to such information, that may be considered confidential by the alliance/ collaborations of the auditor.
Information about the total revenue of the auditor and its network firms
Under this, the auditor is required to disclose total revenue generated from professional services which would be divided into two parts, first, revenue generated from statutory audit fee and Second, revenue generated from Non-audit service fee. These groups are further divided into two sub-part which require categorizing the revenue generated from clients governed by NFRA and from other clients. Similarly, sub-categorizing to be done for revenue generated from non-audit services. The auditor is required to disclose break-up of its non-audit service fee which comprises (A) fees from attestation/ assurance services, (B) Fee from taxation services and (C) Fee from other non-audit services. The revenue under these break-ups must be disclosed in respect of clients governed by NFRA and clients not governed by NFRA.
[1] Report of the Committee can be accessed at – https://www.mca.gov.in/Ministry/pdf/2018_CommitteeExperts_Report_08112018.pdf
[2] The market capitalization list for the six months ending December 2022 can be accessed at – https://www.amfiindia.com/Themes/Theme1/downloads/AverageMarketCapitalizationoflistedcompaniesduringthesixmonthsended31Dec2022.pdf
Our snippet on the same can be accessed here
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