Analyzing the Companies (Audit and Auditors) Rules, 2014
December 19, 2015
Financial Reporting Council’s investigation into Grant Thornton’s audits of the consolidated financial statements of Globo PLC for the years ending 31 December 2013 and 31 December 2014 opens up yet another discussion on the scope of powers administered with the Auditors. The autonomous auditing agency (Comptroller and Auditor General) of India established under Article 148 of the Constitution of India responsible for auditing of all the receipts and expenditure of the Government of India and the state governments, recently tabled its Report No.38-2015- Union Government (Defense Services) Air Force in the Indian parliament on 18th December, 2015, wherein it inter alia stated that:
“the operational readiness of Su-30MKI was low due to high rate of AOG (Aircraft on Ground), low serviceability and less achievement in flying hours.”
The report further states that the Russian made Su-30MKI aircraft suffers from poor serviceability, which against the prescribed norm of 75% is just around 55%- 60%. With the Indian Prime Minister’s Russia visit scheduled for December 24 - December 25, 2015 it will be interesting to see what talks are advanced by both sides based on the observations made in the said CAG’s report.
Auditors as vigilantes seek to promote accountability, transparency and good governance through standardized and effective auditing. They independently inspect an organization’s accounts officially and exercise substantial control over the accuracy of data and effectiveness of systems governing a company. They ensure that organizations are maintaining accurate and honest financial records and statements. They therefore exercise immeasurable control over the fate of a company. The broad objectives of an audit are to ensure legality, regularity, economy, efficiency and effectiveness of financial management and public administration mainly through financial, compliance and performance audit. This even though ensures transparency, giving so much power to the auditors also increases the likelihood of manipulation. Therefore, it is important to keep the auditors’ actions under stringent checks and balances through effective legislations.
Vide notification no. G.S.R.246(E) dated 31.03.2014, the Ministry of Corporate Affairs in supersession of the Companies (Central Government’s) General Rules and Forms, 1956 (in so far as they relate to matters covered under the said rules) the central government enacted the Companies (Audit and Auditors) Rules, 2014.
This Paper seeks to provide an interim update about the Companies (Audit and Auditors) Rules, 2014, the impact of the recent amendments to the said rules on the already existing legislations and further evaluate implications of these rules on the Auditors.
I. Companies (Audit and Auditors) Rules, 2014 (31.03.2014)
Rule 3: Manner and procedure of selection and appointment of auditors
The Companies (Audit and Auditors) Amendment Rules, 2014 (the Audit Rules), give the power to the Board of Directors (BoD) or the Audit Committee (AC) (where the committee is required to be constituted under Section 177 of the Act), to take into consideration the qualifications and experience of the individual or a firm suggested to be considered for appointment as an auditor and also assess whether such qualifications and experience are appropriate to the size and requirements of the company. The rules further direct the BoD or the AC who while considering the appointment are to ensure that there is no order or pending proceeding relating to professional matters of conduct against the proposed auditor before the Institute of Chartered Accountants of India, or any competent authority, or any Court.
Subject to the aforesaid assessment, the AC, shall recommend the name of an individual or a firm as a proposed auditor to the BoD, or in other cases, the BoD shall recommend the name to the members of a company in the annual general meeting (AGM) for appointment. If the BoD is in conformity to the recommendation of the AC, it shall further the same to its members, however, if the BoD disagrees with the recommendation of the AC, the said recommendation is remanded back to the AC with reasons for such disagreement. The AC after considering the reasons of the BoD can decide whether or not to reconsider its original recommendation. If the AC decides against reconsideration of its original recommendation, the BoD after recording its reasons for disagreement and selecting its own recommendations, shall place the matter for consideration of the members in the AGM.
The auditor appointed in the AGM shall hold office from the conclusion of that meeting in which he was appointed till the conclusion of the sixth AGM, for the purposes of which, the meeting of appointment of the auditor shall be considered as the first meeting. Such appointment by way of an ordinary resolution shall be subject to ratification in every AGM till the sixth AGM. 
As per Rule 3 of the Audit Rules, the AC and the BoD are required to ensure that the proposed auditors do not have any orders/pending cases against them, in any court or before any competent authority. The AC’s recommendations are to be considered by the BoD, who shall give the final list to the members. This rule ensures that the decision to appoint an auditor is taken unanimously, while resting the ultimate power in the hands of the members of the company whose vested interests are of prime importance. This rule puts the powers of appointment of an Auditor AC or BoD at the same pedestal.
Conversely, Rule 3 does not define the scope of power of rejection vested with the members of a company. It does not ascertain whether the members are required to select an auditor from the proposed recommendations, or could reject them all for the reasons best known to them. Nevertheless, with independent directors forming a majority of the AC in terms of Section 177 of the Companies Act, 2013 (the Act), it is ensured that the recommendations so made under this Rule are not manipulated.
Rule 4: Conditions for appointment and notice to Registrar
As per the said rule, the appointed auditor (individual or a firm) is required to submit a certificate confirming eligibility for appointment in terms of the Act, the Chartered Accountants Act, 1949 and the rules or regulations made thereunder, proposed appointment is for a term, which in conformity to the provisions of the Act, is within the limits laid down by or under the Act. In the said certificate, the appointed auditor is required to certify and disclose any and all pending proceedings against the said auditor, or in the case of a firm, any partner of the audit firm, pending with respect to professional matters of conduct.
Auditors (individual or firm) seek to guide an organization’s decisions and policies on the disclosure of information to its employees and the public. The audit report is an investor’s primary source of information about the audit. This further necessitates disclosure of all the information pertaining to the auditor’s/auditor firm’s credibility, which is a significant element that ensures that the proposed auditor or firm shall give effect to authentic auditing and further advances good governance practices of the company.
This Rule seeks to shift the onus of responsibility from the company to the auditor. With a certificate of confirmation, this rule seeks to protect the company’s goodwill and hold the auditor (individual or a firm) accountable for their own operations.
Rule 5: Class of Companies
Section 139 (2) of the Act reads as under:
“(2) No listed company or a company belonging to such class or classes of companies as may be prescribed, shall appoint or re-appoint—
(a) an individual as auditor for more than one term of five consecutive years; and
(b) an audit firm as auditor for more than two terms of five consecutive years:
(i) an individual auditor who has completed his term under clause (a) shall not be eligible for re-appointment as auditor in the same company for five years from the completion of his term;
(ii) an audit firm which has completed its term under clause (b), shall not be eligible for re-appointment as auditor in the same company for five years from the completion of such term:
Provided further that as on the date of appointment no audit firm having a common partner or partners to the other audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of five years:
Provided also that every company, existing on or before the commencement of this Act which is required to comply with provisions of this sub-section, shall comply with the requirements of this sub-section within three years from the date of commencement of this Act:
Provided also that, nothing contained in this sub-section shall prejudice the right of the company to remove an auditor or the right of the auditor to resign from such office of the company.”
Rule 5 seeks to determine the scope of the words ‘the class of companies’ used in Section 139 (2), to constitute: all unlisted companies having paid up share capital of rupees 10 crores or more; all private limited companies having paid up share capital of rupees 20 crores or more and all companies below the aforementioned threshold limits, but who have public borrowings from financial institutions, banks or public deposits of rupees fifty crores or more.
Section 139 (2) puts a bar on reappointment of an auditor for more than one term of five consecutive years and an audit firm as auditor for more than two terms of five consecutive years, with a bar on consecutive appointment of an individual auditor already appointed by the said company for a term. It also puts a restriction on the reappointment of an audit firm having common partners to any other audit firm, whose tenure has expired in a company immediately preceding the financial year of such reappointment.
Clearly, Section 139 (2) seeks to deter long-term relationships between auditors and their clients, which increases the risk of audit failure, owing to auditors being influenced by friendships that may lead to them losing objectivity and professional skepticism. Rule 5 seeks to classify the companies to whom the said provisions shall apply and seeks to define brackets on the basis of the paid up share capital investments in them (i.e. minimum of Rs.10 crores). This rule seeks to adopt a more practical approach to the current investment scenario prevailing in the country, which is determined on the basis of current market conditions and other factors such as cost of living and per capita income in the country. However, it doesn’t extend to the companies with less than Rs.10 crores of paid up share capital or public borrowings. Rule 5 therefore, is found limited in its scope.
Rule 6: Manner of rotation of auditors by the companies on expiry of their term
Rule 6 describes the manner in which the auditors shall be rotated on expiry of their term. The AC shall recommend to the BoD, the name of an auditor (individual or a firm) who may replace the incumbent auditor on expiry of the term of such incumbent. In cases where a company is required to constitute an AC, the BoD shall consider the recommendation of such committee, and in other cases, the BoD shall itself consider the matter of rotation of auditors and make its recommendation for appointment of the next auditor, who shall be appointed by the members in annual general meeting. For the purpose of rotation of auditors, the period for which the individual or the firm has held office as auditor prior to the commencement of the Act, shall be taken into account for calculating the period of five consecutive years or ten consecutive years, as the case may be.
Rule 6 further clarifies that the incoming auditor or audit firm shall not be eligible if such auditor or audit firm is associated with the outgoing auditor or audit firm under the same network of audit firms. Further, where a firm has appointed two or more individuals or firms or a combination thereof as joint auditors, the company may follow the rotation of auditors in such a manner that both or all of the joint auditors, as the case may be, do not complete their term in the same year.
Note 1 to the Illustration to Rule 6(3), which has been provided to illustrate the manner in which the Rule should operate, appears to expand the scope of the Rule itself, and requires the time served by multiple audit firms to be considered. As regards compliance of the rotation policies by the companies, for every company that may be in existence before the commencement of the Act, the last date for such compliance is 3 years from the date on which the relevant provisions of the Act came into force i.e. 01.04.2014.
These mandatory provisions and rules for rotation of auditors (individual or firm) shall definitely strengthen the independence among auditors and prevent auditors from making relationships and bonds with the managers. The rotation policy established under the Act and this Rule shall gain increasing importance in the next couple of years, particularly around 01.04.2017, when companies will have to start determining the requirement to rotate their auditors.
Rule 7. Removal of the auditor before expiry of his term
Rule 7 enumerates the procedure that needs to be followed for removal of an auditor before expiry of his term. Before effecting such removal, the board of directors has to pass a special resolution and write an application in this regard to the Central Government in Form ADT-2, accompanied with the requisite fees, within 30 days of such a resolution passed by the Board. After the company receives an approval from the Central Government, it shall hold a general meeting within sixty days of receipt of such approval.
Rule 8. Resignation of auditor
In terms of Section 140 (2) of the Act, an auditor who resigns from the company shall file a statement in the prescribed form with the concerned company and also with the Registrar. In case of government owned companies, or companies directly or indirectly owned or controlled by the government (by either state or central government, or by one or more state governments) in terms of Section 139 (5) of the Act, the concerned auditor shall also file such statement with the Comptroller and Auditor-General of India. Such statements are to be accompanied by reasons and other facts as may be relevant with regard to such resignation. Rule 8, simply enumerates a procedural requirement of filing such a statement in Form ADT-3.
Rule 9. Liability to devolve on concerned partners only
Rule 9 determines the criminal liability of an audit firm (other than fine), which shall devolve only on the concerned partner or partners, who acted in a fraudulent manner or abetted or, colluded in any fraud. While determining the responsibility for the liability, this rule uses the words ‘other than fine’. It however does not ascertain who would be liable for the fine, if any, so levied on account of criminal liability.
Rule 10. Disqualification of auditor
Section 141(3)(d)(i) of the Act, bars a person from being an auditor of a company who, or his relative or partner is holding any security of or interest in the company or its subsidiary, or of its holding or associate company or a subsidiary of such holding company. The proviso to the said section sets the maximum limit of security or interest that may be held by a relative of an auditor in a particular company of face value not exceeding one thousand rupees or such sum as may be prescribed.
Rule 10 gives the liberty to the relatives of an individual or a firm who is or is proposed to be an auditor to hold securities in the company of face value of maximum Rs.1,00.000/-. The condition under this sub-rule shall also be applicable in the case of a company not having share capital or other securities. Rule 10 also prescribes the procedure to be followed by the auditor in the event of a relative acquiring security or interest, above the threshold prescribed, who shall ensure that the limits so prescribed under Rule 10 are maintained and any corrective action to be taken in this regard shall be taken by the auditor within 60 days of such acquisition or interest.
Rule 10 further determines the prescribed amount under Section 141(3)(d)(ii) the Act as Rs.5,00,000/-. Any interest in excess shall prevent the auditor from being eligible. For the purpose guarantee or security for indebtedness in terms of Section 141(3)(d)(iii), an amount in excess of Rs.1,00,000/- shall disqualify the appointment of a person