In summary, the guidelines require mandatory rotation of auditors after three years with a six-year cooling-off period; appointment of joint auditors in certain cases; a restriction that each auditor can audit only eight NBFC’s; and significant restrictions on other services (both audit and non-audit) that an auditor can provide to group entities of the audited entity.On April 27, 2021, the Reserve Bank of India (RBI) issued new guidelines on the appointment of statutory auditors by banks, and Non-Banking Financial Companies (NBFC’s) above a threshold. For covered entities, these guidelines represent very significant changes. In summary, the guidelines require mandatory rotation of auditors after three years with a six-year cooling-off period; appointment of joint auditors in certain cases; a restriction that each auditor can audit only eight NBFC’s; and significant restrictions on other services (both audit and non-audit) that an auditor can provide to group entities of the audited entity.
These requirements are significantly more stringent than the requirements of the Companies Act, which otherwise governs many of these entities. Covered entities are required to comply with the guidelines for the current year itself.
The guidelines may be well-intentioned and rightfully aimed towards improving audit quality by prescribing thresholds of prior experience, technology qualifications, and setting a higher bar for auditor independence. However, there may be several unintended consequences arising from the application of the guidelines, and several banks and NBFC’s may struggle to comply with the requirements. It may be worthwhile to step back and review previous experience in India and globally to determine whether the objectives of audit quality and auditor independence are likely to be met through the approach prescribed by the guidelines, and at what cost for the companies impacted.
Indian companies have been following mandatory auditor rotation since April 1, 2017. To recap companies can appoint their auditors for two terms of five years each and are then required to rotate their auditors with five years cooling-off period.
The same requirement applies to audits of insurance companies and mutual funds. Banks are currently required to rotate their auditors after four years with a cooling-off period of six years. The current norms in India are in any case more stringent than global norms. For example, in the European Union, the general rule is to mandatorily change auditors after 20 years, while in the US, there is no requirement to rotate auditors.
Given the size and complexity of many banks and NBFC’s and the judgment involved in auditing them, the new three-year rotation period may be too short since the time the auditor gains knowledge and experience of auditing the entity, they will need to move out of the audit.~
Thus, rather than enhancing audit quality, this may practically have the opposite effect. Further, companies and their finance teams may need to invest significant time to manage auditor transition at short intervals.
Similarly, joint audits in India have been previously considered by committees set up by the Ministry of Corporate Affairs (MCA). On balance it has been determined that joint audits would result in an increase in costs and efforts for companies without any significant benefits. Very few countries across the world have mandated joint audits, and in fact, countries such as Denmark and Canada have discontinued historical joint audit requirements for the same reasons.
Further, there is little precedence for a cap on the number of audits being conducted by an audit firm. This matter was recently evaluated both in India by a committee formed by the MCA and separately in the UK, to determine whether such caps would be helpful. On balance, the general view is that any cap may result in an artificial distortion in the market whereby emerging growth companies may not be able to attract large and experienced audit firms as their auditors.
The guidelines also seem to suggest that the selected auditor cannot even provide audit services to group entities. This may make the task of finding an eligible auditor very difficult for companies.Finally, the new guidelines require selected auditor would need to be independent not just of the audited entity, but of all companies in the group. The definition of a group is very wide and extends significantly beyond the general norms that apply in India or internationally. The selected auditor is required to be independent not just for the period audited (as is the norm in India and globally), but for one year before and one year after the audit. The guidelines also seem to suggest that the selected auditor cannot even provide audit services to group entities. This may make the task of finding an eligible auditor very difficult for companies.
Given the significant implementation issues that the guidelines are throwing up, it may be advisable for the regulator to defer the timelines beyond 31 March 2022, particularly given the uncertain business environment due to COVID-19. In parallel, the regulator should consider setting up a committee comprising a cross-section of all impacted stakeholders (banks, various types of NBFC’s, industry & professional associations, and auditors) to evaluate and solve the various practical challenges.
While there is all-round agreement on the need to enhance audit quality and auditor independence, care should be taken to ensure that the steps are taken truly achieve these objectives without undue hardship. Else, we may inadvertently end up doing more harm than good.
About the author: Jamil Khatri – Partner, BSR&Co.
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