Accounting and accountability

Updated: Jan 29 2002, 05:30am hrs
The collapse of Enron is the largest bankruptcy case in corporate history. The biggest fallout of this debacle has been the focus on Enrons auditors, Andersen. The affair has assumed grave proportions and at least eight committees of the US justice department are probing the same. The Securities Exchange Commission has initiated a separate investigation and Andersen personnel are required to testify before the US Congressional hearing. The general feeling is that Andersens professional standing is bound to take a hammering. While the outcome is awaited, it is worthwhile examining in the Indian context whether the system can provide adequate safeguards in a similar situation

Under the Indian law, while income tax audit is for tax purposes, company audit is intended to safeguard investor interests. In brief, an auditor has to make a report to the shareholder on examination of the companys accounts and other relevant documentsas to veracity and fairness of the same. The auditor is specifically to indicate whether the financial conduct of the companys affairs can have an adverse affect on its functioning. For this purpose, the auditor can have access to the relevant books and all documents of the company. Though, companies are unlikely to indulge in false inflation of profits for obvious reasons, manipulation of accounts in various other ways detrimental to shareholder interest is always possible and not uncommon. The shareholder only has the auditor to ensure that his investment is utilised properly and is not misapplied or misappropriated without his knowledge. The integrity and vigilance of the auditor is therefore crucial. Independence of the auditor is foremost and his duty is to prevent loss to the investor by bringing to his notice any irregularity in the companys investments.

What does the auditor do when he thinks that there are discrepancies in the accounts He may give a qualified opinion, that is, express his reservations clearly and provide reasons. Alternatively, he may give an adverse opinion, with reasons that the financial statement does not express a fair view of the affairs of the company. In so far as the statutory documents are concerned, this is the auditors statutory obligation. But what is the auditors accountability, his duty, not just qua the directors of the company and the shareholders but the wider world of the regulatory authorities and public interest

In the case of Kingston Cotton Mills, the House of Lords have held that the auditor is only a watchdog and not a bloodhound. This case proceeds on the basis that the auditor has only to exercise reasonable care and caution and is not liable for tracking out carefully constructed schemes of fraud. But standards of care and vigilance change over time. In the words of Lord Justice Denning, the auditors task is to take care that errors are not committed, whether they are errors of computation, omission or commission or downright untruths.

What then is the remedy when the auditor does not observe the required vigilance and circumspection Can he be prosecuted by the shareholder Can he be sued for damages Can he lose his licence and be debarred from practice Sections 21 and 22 of the Chartered Accountants Act, 1949 vests the Council of the Institute of Chartered Accountants with disciplinary powers in case of professional misconduct. Under these provisions, in cases of malpractice, negligence, failure to discharge duties etc., an auditor could have even his licence cancelled for five years. In more serious cases, the Council refers the matter to the High Court. Section 543 of the Companies Act provides the remedy to recover damages where an auditor is guilty of misfeasance or breach of trust. This section however is applicable only to companies in liquidation. Otherwise, an action for damages under common law can be filed in a case of negligence by the auditor. In case the auditor discovers a serious fraud, he should immediately report this to the appropriate person. The auditing guidelines (February 1999) acknowledge that there may be occasions when it is necessary for an auditor to report a fraud or other irregularities. Such duty overrides the duty of confidentiality.

In the case of Sasea Finance Ltd Vs KPMG (decided in 2000), the Court observed that no loss would have incurred from the date of discovery of the financial irregularity, if the auditor had taken timely action to blow the whistle. In view of this change in thinking, there have been demands from the auditors lobby at an international level for a policy to limit auditors liability so that the burden in a given case is primarily that of directors. Their case is that at best an auditor can be made liable for contributory negligence. Perhaps the said limitation may help in avoiding frivolous litigation and provide for adequate insurance cover for all concerned; but ultimately, effective audit is the key to transparency of a companys functioning. Hopefully, the Andersen-Enron case will lead to reforms in the accounting profession.

Kumkum Sen is a corporate lawyer and a partner in Khaitan & Khaitan, a Delhi law firm