Set The National Financial Reporting Authority Free
The National Financial Reporting Authority is India’s first independent regulator of accounting and auditing. Since 2018 when it was set up, it has recommended accounting and auditing standards, published audit quality review reports, and investigated and punished chartered accountants. It needs to do more to fulfil its mandate to protect investors, creditors and other users of financial statements and the public interest. This two-part series evaluates the current legal framework and makes a case for a separate law that would facilitate NFRA’s development as an effective, efficient, independent, and accountable regulator.
A Fraught Birth
The yearslong fraud in Satyam Computer Services that came to light in 2009 but was not detected by its auditors Price Waterhouse led to an outrage. Commentators blamed the shoddy auditing on weak supervision by the Institute of Chartered Accountants of India—the accounting industry association—and urged independent regulation by an external body with necessary powers.
Reflecting the strong public sentiment, several Parliamentary Committees recommended the creation of an independent auditing regulator. As a result, section 132 of the Companies Act, 2013, provided for the establishment of NFRA. Though the rest of the Act came into effect, the ICAI opposed independent regulation and thwarted NFRA.
On July 1, 2017, Chartered Accountants’ Day, Prime Minister Narendra Modi criticised CAs in his address at an ICAI function.
The Prime Minister made a number of unflattering observations about the conduct of CAs and the ICAI’s disciplinary record. Even after that, NFRA was not set up.
Finally, Half A Regulator
On Feb. 14, 2018, Punjab National Bank disclosed to the stock exchanges that it had discovered $1.77 billion (about Rs 11,400 crore) worth of fraudulent transactions in one of its branches in Mumbai. Public sector banks have an assortment of audits done by CAs including statutory, branch, concurrent, and stock audits. PNB paid audit fees totalling Rs 78.15 crore in 2017-18. So, the massive fraud raised questions about the effectiveness of bank auditing. Faced with an uproar, on March 1, 2018, the government finally announced the setting up of NFRA, which started functioning on Oct. 1, 2018.
Bizarrely, NFRA included three elected members of the ICAI’s council – president and chairpersons of the accounting standards and the auditing and assurance standards boards – all practising CAs, whose conduct NFRA is required to regulate. With the inclusion of three members from the industry association, NFRA’s independence has been compromised from the start. For good measure, two more CAs were later nominated as part-time members. As a result, practising CAs make up five of the nine part-time members in NFRA.
Menaka Doshi has documented how the ICAI subverted the will of Parliament and its Committees, defied the authority of the government, and ignored the strong public opinion in the country. The ICAI has continued its campaign against NFRA.
Evaluation Of The Current Legal Framework
NFRA is regarded as a part of the government. Therefore, its expenditures are met by the government and it is governed by the systems and rules for the appointment and remuneration of civil servants. This setup has significant implications for its operating and financial autonomy and working efficiency. There are other problems with the current setup. The following are the major shortcomings of the current legal framework:
1. Influence of the accounting industry association
The institutional design of the regulator should provide confidence to investors, creditors and users of financial statements that the regulatory process is credible, legitimate, and predictable. The regulator should maintain an arm’s-length relationship with the regulated entities for its actions to have legitimacy. It may be noted that the National Advisory Committee on Accounting Standards an advisory body which NFRA has replaced, had just one member from the ICAI, its president. It is not clear why NFRA, a regulatory body, has five CAs in practice. These five members are potentially conflicted because of their being a part of the regulator while being regulated entities themselves, besides representing the industry association. It is not obvious how their presence would advance independent regulation.
No other major regulator in India, such as SEBI, IRDAI, TRAI, RERA, CERC, and the CCI has members drawn from their regulated entities.
Further, RERA, CERC and CCI have only full-time members. It would be unthinkable for the U.S. Public Company Accounting Oversight Board, the U.K. Financial Reporting Council or the Australian Securities and Investments Commission to include members of the local industry associations.
This peculiar model for NFRA has also been noticed outside India. In a report published by the Hong Kong-based CLSA and the Asian Corporate Governance Association, India was rated the lowest on corporate governance in Asia with 39 out of 100 points in the ‘auditors & audit regulators’ category, the region’s average being 68. Commenting on their inclusion, the report states: “Audit regulation is another big theme, with news that the region’s three traditional laggards—Hong Kong, India and the Philippines—are finally making progress. The Philippines is out front and has already joined IFIAR, the International Forum of Independent Audit Regulators. Hong Kong should finally see an independent audit regulator in 2019. While India moved to set one up in 2018, its status is unclear as the government permitted the local industry association to have influence on the new regulator’s governing body.”
2. Insufficient autonomy from the government
According to the OECD, “establishing a more independent regulator can send an important message to regulated entities about the commitment of government to objective and transparent administration and enforcement of regulation.” According to a World Bank document, the characteristics of an independent regulator would include the following:
Having clearly defined functions and accountability;
Being located at the centre of government;
Having a relatively high level of transparency and independence from the executive arm of government; and
Having staff with a wide range of public and private sector backgrounds.
NFRA’s position in the government’s hierarchy severely constrains its autonomy. Since NFRA is an office within the Ministry of Corporate Affairs, its expenses are met entirely out of funds allocated to it from the government’s annual budget. In official terminology, NFRA is an “attached office” or “subordinate office” like the CPWD. As a result, it’s subject to the government’s rules for appointment and remuneration of personnel, procurement of specialist services, the exercise of financial powers, and other matters. These requirements hinder NFRA.
3. Restricted role in financial reporting
Financial reporting comprises the preparation and audit of financial statements. Therefore, NFRA should be able to review the work of both preparers and auditors and take action. It turns out that NFRA’s scope is practically restricted to reviewing audit quality and taking disciplinary action against auditors. Under rule 7 of the National Financial Reporting Authority, 2018, NFRA can review a company’s financial statements, direct its officers to provide additional information or explanation, and require their personal presence.
However, it cannot impose any penalty for professional or other misconduct on them under sub-section (4) of section 132 of the Companies Act, 2013 in case of violation of accounting standards. The Act gives NFRA powers to impose a penalty only on auditors.
They include chief executives, chief financial officers, audit committee chairs and members, independent directors, internal auditors, and other officers. Besides, company staff and external experts such as cost accountants, company secretaries, lawyers, actuaries, valuers, MBAs, and IT service providers (and none of the above) may have a role in financial reporting. Thus, NFRA will not be able to develop into a regulator of the full spectrum of financial reporting.
4. Excessive reliance on subordinate legislation
A noteworthy feature of section 132 is that it leaves a number of important matters to be covered in the rules issued by the government. For example, NFRA’s composition, functions and duties and appointment and remuneration of members are all dealt with in the rules rather than in the Act itself. While only Parliament can amend the Act, the government can amend the rules. The protection available under a statute is higher than under the rules. This has significant implications for the independence of NFRA.
The current legal framework has a number of shortcomings that come in the way of NFRA evolving into an independent and effective regulator of financial reporting. The next part of this column will present a new legal framework built on an institutional design more appropriate for NFRA.
R Narayanaswamy is a Retired Professor of Finance and Accounting, Indian Institute of Management, Bangalore, and Chair, Technical Advisory Committee of the National Financial Reporting Authority. Views are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.