IMA India Session Highlights Recent Regulatory Developments and its Implications

The NFRA has emphasised the need for auditors to apply ‘professional scepticism’ and make independent judgments rather than relying on legal opinions provided by legal teams.

Two recent regulatory and judicial developments will have a profound impact on the Finance community. A June 2023 circular of the National Financial Reporting Authority has led to serious disagreements between the auditors and the audit committee about the reporting of fraud to the Ministry of Corporate Affairs (MCA). Separately, SEBI has started treating non-compliance with accounting standards by a company as ‘fraud’ in the financial statements and has initiated proceedings under the PFUTP Regulations. At a recent online session of the CFO NxT Forum, Bharat Vasani, Senior Advisor – Corporate Laws at Cyril Amarchand Mangaldas, shared his views on the potential implications and way forward for Finance professionals and corporates to tackle these regulatory changes.

The National Financial Reporting Authority (NFRA) has intensified its oversight of auditors, enforcing strict penalties for negligence as well as for failure to report accounting fraud. It has issued approximately 65 orders against auditors to date, highlighting significant deficiencies in their practices, including a critical review of the ‘Big Four’ accounting firms. This underscores the imperative for adherence to accounting standards, a principle further reinforced by SEBI’s ‘Zero Tolerance’ stance on violations. Such breaches are increasingly viewed under a severe lens, and occasionally classified as fraud, presenting profound consequences for company Directors as well as the broader Finance community. The increasingly detailed and prescriptive approach to regulation also reflects a growing trust deficit between regulators and Corporate India.

Simultaneously, the internal landscape of corporate governance/compliance within Indian businesses is shifting. Increasingly, organisations are categorising as fraud mere violations of the code of conduct, thus possibly reducing the perceived severity of such acts. Concurrently, the complexity and scope of compliance obligations have expanded significantly, encompassing a broad range of legal domains and imposing a substantial burden on businesses. This includes the incorporation of income tax and GST considerations into boardroom discussions, previously uncharted territories for many companies. Additionally, the lack of familiarity with Indian Accounting Standards (Ind AS) among many Audit Committee members and CFOs, who heavily depend on auditors, further complicates compliance efforts. As a result, the cost and complexity of compliance for corporate India have increased significantly, impacting the operational and strategic facets of business management.

Accounting Fraud and the June 2023 NFRA Circular of June, 2023

On June 26th, 2023, the NFRA issued a stringent circular criticising auditors for failing to report fraud as required under Section 143(12) of the Companies Act, 2013. The NFRA has emphasised the need for auditors to apply ‘professional scepticism’ and make independent judgments rather than relying on legal opinions provided by legal teams.

• Contradictions between NFRA and ICAI guidelines: NFRA’s directive starkly contrasts with ICAI’s February 2016 guidance note, which states that only frauds first identified by auditors need to be reported under Section 143(12). However, NFRA mandates the reporting of all frauds directly to the MCA if they exceed Rs 1 crore, diverging from ICAI’s stance and prior practices that allowed companies to limit reporting based on the auditor’s discovery of fraud.
• Variances between auditing standards and reporting requirements: SA 240, endorsed by both ICAI and NFRA, limits auditors’ reporting obligations to frauds that cause a material misstatement in financial reports. This creates a complex scenario of differing interpretations between ICAI and NFRA regarding the extent of fraud reporting.
• The fallout: The NFRA’s aggressive approach is forcing auditors to take an ultra-conservative stance, both to ensure compliance and out of fear of repercussions under SEBI’s FUTP regulations, Section 447 of the Companies Act and the PMLA, under which fraud is now a scheduled offence, bringing potential scrutiny from the Enforcement Directorate. The move has also bred serious and disagreements within some Audit Committees.

An Expanded Definition of RPTs

• Expansive definition and consequences for Related Parties (RPs): The definition of RPs given by SEBI has evolved significantly. In April 2023, the SEBI included any entity possessing a minimum of 10% shareholding within a company under the RP ambit. This has further complicated decision-making processes as this would mean even stakeholders without significant control within an organisation are now a RP. In certain cases, this would include private equity firms and even the government.
• Difficulties in procuring SEBI clarifications: Despite repeated solicitations for clear guidance and the publication of FAQs by SEBI, there remains an evident lack of formal directives. Legal advisors are discouraging corporates from seeking ‘informal guidance’ from SEBI, as it tends to be extremely conservative.
• A broad range of RPTs: SEBI regulations capture a broad spectrum of RPTs, including those conducted at the subsidiary level and even transactions aimed at indirectly benefiting a related party. This expansive definition imposes significant operational burdens on corporations in monitoring and administering transactions, which is further compounded by the necessity to report detailed disclosures to shareholders and audit committees.
• International and cross-border RPT challenges: The international operations of many MNCs introduce further complexities, such as conflicting legal requirements and regulatory scrutiny of cross-border RPTs.
• Impact of proxy advisory firms and shareholder activism: The wide-ranging criteria for RPTs have led to heightened oversight by proxy advisory firms, culminating in a significant tally of RPT proposals being overturned at general meetings. This activist stance highlights the necessity for more definitive guidelines on which transactions warrant detailed scrutiny.
• Ambiguity regarding ‘Arm’s Length’ pricing: A persistent, unresolved issue is the absence of a stipulated methodology for ascertaining arm’s length pricing for RPTs. Although transfer pricing methodologies under the Income Tax Act are relied upon, SEBI has yet to endorse these methods, leaving audit committees to tread cautiously amidst this uncertainty.

Navigating Disclosure Requirements and Valuation Regulations

• Amendments to disclosure requirements: SEBI has revised Regulation 30 of LODR, mandating the disclosure of 26 deemed material items and an additional 13 items based on materiality thresholds related to turnover (2%), net worth and average PAT (5%). This presents serious challenges, particularly because the thresholds are often disproportionately low. Moreover, there are often significant variances in these metrics, especially for investment companies lacking domestic turnover. Industry bodies like the CII, FICCI and ASSOCHAM are engaging with SEBI to seek adjustments.
• Rumour verification requirements: Tightened regulations for the top 350 listed companies require the confirmation, denial or clarification of market rumours, impacting market prices and potentially making transactions costly. This is under review with SEBI, which has sought public input on the matter.
• Mandatory disclosure of all fines and penalties: The requirement to disclose all fines and penalties, regardless of their materiality, has led to the dilution of significant disclosures, with efforts underway to address this concern through dialogue with SEBI.
• Re-approval of special investor rights: The introduction of Regulation 31B in LODR necessitates the re-approval of special rights to investors every five years, creating uncertainty over contract enforceability and legal challenges, particularly for foreign investors.
• Greater scrutiny of valuations: Regulators such as SEBI and the RBI, as well as the MCA and the Income Tax department, are scrutinising company/share valuations much more intensively than before. Disputes such as the PNB Housing Finance case highlight the complexities involved in valuations. In light of complications identified in this case, SEBI amended Regulation 164 of ICDR for clearer price determination. It stated that in case the company’s articles mandate that the price should be determined by a registered valuer, and if this determined price is higher than the one computed by the standard formulas, then the higher price will prevail.
• Regulatory consistency in valuations: Amendments to Rule 11UAE of the Income Tax Act seek to harmonise valuation methodologies across regulatory frameworks, emphasising the importance of registered valuers and consistent valuation practices in both M&A and corporate restructuring cases.