Auditor’s Liability in Detection of Fraud: Too Liberal or Too Stringent
This article is authored by Monika Saxena, a 4th-year law student at National Law University Odisha, Cuttack.
In a recent ruling of Devas Multimedia Pvt. Ltd. v. Antrix Corporation Ltd., the Honorable Supreme Court of India (“SC”) while giving its judgment in favour of Antrix Ltd., ordered winding up of Devas Multimedia Private Limited (“DMPL”), for the very first time on the grounds of fraud. It also laid down certain observations which might unearth some interesting questions of law regarding the accountability of the auditors in reporting fraud during the auditing process. In this article, the author analyses the aforementioned ruling and the obligations of the auditors in light of the existing legal framework, designed by both the legislature and the judiciary.
Background of the case:
In 2005, DMPL entered into an agreement with Antrix to instate an operational SBand satellite, pursuant to which it obtained necessary approvals and license and brought foreign investment in India. However, Antrix invoked the force majeure clause in 2011 and terminated the agreement citing the reason of policy decision taken by the Indian government, which resulted into arbitration proceedings.
In the meantime, criminal investigation was initiated against DMPL on the grounds of fraud contending that the officials of Antrix and DMPL colluded to enter into an agreement for the technology that neither existed at the time of entering into the agreement and nor when the approvals were taken. Therefore in 2021, Antrix filed a petition before NCLT Bengaluru for winding up of DMPL as per Section 271(c) of the Companies Act, 2013 (“Act”). Subsequently, the NCLT and the NCLAT passed a reasoned ordered for winding up of DMPL, which prompted an appeal before the SC to address the concerns raised only on the questions of law, under Section 423 of the Act.
During the proceedings, DMPL contended that the Auditor’s Reports issued by Antrix year by year did not mention of any such fraud committed on the company. Instead, the Auditor’s statements in the annual reports certified that no fraud was committed, which would give rise to a valid plea of estoppel against Antrix. Addressing this contention, the SC remarked that “the auditor’s report can neither be taken as gospel truth nor act as estoppel against the company” and is only based on the information given to them.
Thus, it held that the Auditors cannot be held accountable for certifying any information with a bona fide intent in their report and a clean chit by them does not absolve the corporate management. The court rejected the plea of estoppel notwithstanding the shortcomings in Auditor’s Report. Ergo, after ascertaining that undue favors have been extended to DMPL and fraud being perpetrated by it in terms of misrepresentation w.r.t. the possession of IPR over device, offer of a non-existent technology, securing of an experimental license fraudulently, etc. ordered for winding up under Sections 271 and 272 of the Act.
Existing Legal Framework:
Due to this decision of the SC, one conclusion that can be culled out is that the auditors are only responsible to report fraud to the extent of information given to them by the management of the company and not beyond that. However, in such situations, some very pertinent questions could be raised regarding the evidentiary value of audit reports and liability of auditors. To answer the same, it is relevant to first understand the legal framework already established to determine the accountability and liability of the audit reports and the auditors.
Section 140(5) of the Act provides for dismissal of a company’s auditor upon satisfaction of fraud which would effectively ban them from working as an auditor for any company in India for the next five years, even without definitive evidence of their guilt. The above punishment results from the statutory obligation on the auditors to make inquiries into the management of the company and report any incident that raises suspicions of fraud to the appropriate authority.
In ICAI v. Mukesh Gang the HC, finding auditors guilty of gross negligence and breaching auditing norms, stated that some harsh measures are required to deal with such grave professional misconduct and to set deterrence for others, which would otherwise affect the confidence of public eroding their faith in impartiality and posing questions about the veracity and integrity of the auditing profession as well.
Moreover, the auditors are also obligated to comply with the Standards on Auditing (“SA”) dealing with the responsibility of the auditors to obtain reasonable assurances that the financial statements are free from material misstatement, whether caused by fraud or error. On the same lines, SA 240 mandates that the auditors retain professional skepticism and explore any anomalies discovered during their enquiry, and obligates them to perform a retrospective review of the important management decisions and the financial accounts of the previous years in relation to the significant accounting estimates taken by the company’s management.
These powers and obligations mentioned above clearly indicate that the auditors were not supposed to just sit back but rather take a more proactive approach to deal with corporate frauds, which evidently does not align with the judgment of SC and raises a plethora of issues by diminishing the accountability of auditors. The Indian judiciary has also taken a similar stance earlier by absolving the auditors from any liability on the grounds of erroneous interpretation of law.
On the similar lines, the earlier English ruling in Re Kingston Cotton Mills also highlighted that an auditor ought to be “a watchdog and not a bloodhound” which seems reasonable as they are only obligated to look into the matters provided by the management in the financial accounts. However, the public investing in the companies usually depends on the view of the auditors and therefore expects them to assume a much extensive role in bringing to light corporate frauds and augmenting corporate governance practices. Adapting with this changing viewpoint, the courts then held the auditors accountable to take reasonable care, in order to create deterrence and to save the sanctity of audit reports from diluting and unwittingly diminishing their evidentiary value.
These decisions of the English courts also seem fair in the light of recent corporate scandals such as Satyam Scandal, Café Coffee Day, IL&FS, WorldCom, etc. We can even say that there has been no dearth of such accounting incidents in the last few years. The effects of these incidents could have been averted or lessened had the auditors exercised more oversight and professional judgment instead of just being a mere spectator.
Thus, the Indian judiciary has also increased the accountability of the auditors by pinning liability and responsibility on them in the incidents where the lack of pro-activeness on their part might have aided to the success of corporate frauds. In the ICAI v. P.K. Mukherjee case, the SC stated that the auditors shall perform their duty keeping in mind that they are obligated to inform the stakeholders about the company’s true financial position. They are also expected to step into the shoes of a watchdog on behalf of all the stakeholders and therefore are under a “clear duty towards the beneficiaries to probe into the transactions and to report on their true character”.
In this view, the earlier proposition of an auditor being a ‘watchdog and not a bloodhound’ has started becoming outdated, which the government is also advocating through the “Companies (Auditor’s Report) Order, 2020” that specifies an extensive list of topics on which the auditor must make a statement in the Auditor’s Report. Further, the MCA also released a Consultation Paper, seeking public input on the development of a ‘Composite Audit Quality Index’ to improve the accountability of auditors and audit firms.
These developments have underlined the necessity of probing the accountability of auditors with a sterner lens so that they do not remain mute spectators but take reasonable caution to identify corporate frauds, if any, and communicate them to appropriate authorities. Therefore, the decision of the SC in the DMPL case would definitely be a set back on the efforts put in by the judiciary and legislature in the same front.
The SC has rightly ordered winding up of DMPL since its incorporation itself was for a fraudulent purpose, however, the observation of the SC in diminishing the accountability of the auditors may not be right. In the author’s view, the SC stating that the auditors have no obligation to uncover fraud would weaken public trust in the quality and use of auditing process. In cases like these, if the audit team believes that identifying fraud is not truly their job, then compliance with the requirements of auditing standards on fraud detection may become a rote exercise and not a focus of the audit.
Therefore, the author hopes that while analyzing the role of auditors in fraud detection, the SC shall not provide them any leeway to use the empty excuse that an audit is not a fraud examination. It is completely understandable that they cannot be held liable for every wrong committed by the company but they are still bound to exercise a reasonable amount of care and skill while discharging their duties. It is therefore pertinent to note that an auditor is required to approach their responsibilities with skepticism, to investigate each transaction and to acknowledge that they have a duty for fraud detection, which, while not absolute, is an important obligation that must be pursued actively.