NFRA Releases Series 3 of Audit Committee-Auditor Interactions [Read Document]

The National Financial Reporting Authority (NFRA) has released the third installment of its Audit Committee-Auditor Interactions series, with a specific focus on enhancing the quality of audits and strengthening of corporate governance methods with regard to the audit of related party transactions and disclosures.

The Audit Committee - Auditor Interactions Series 3 specifically addresses the expectations surrounding the audit of related party relationships, transactions, and disclosures under Ind AS 24 Related Party Disclosures, AS 18 Related Party Disclosures, and SA 550 Related Parties.

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Purpose of the Audit Committee-Auditor Interactions Series

The Audit Committee-Auditor Interactions Series is an initiative by the NFRA that is designed to improve the manner and quality of communication between auditors and audit committees. It highlights significant areas of accounting and auditing, providing practical tools for audit committees to engage more proactively with auditors.

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The series touches upon various critical issues that audit committees often stumble upon; this specific inclusion draws attention to related party transactions, an area that has historically been linked with major corporate frauds and one where risks continue to persist.

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Key Focus Areas of Series 3

Series 3 is centred around the audit of related party transactions and disclosures and emphasizes the need for auditors to exercise enhanced skepticism and diligence while auditing related party relationships and transactions.

The series also encourages audit committees to involve auditors on the identification, authorization, approval, and disclosure of related party transactions to ensure that they are conducted on an arm’s length basis and are adequately accounted for. Furthermore, the document provides a set of detailed, illustrative questions that audit committees may use to interact effectively with auditors, covering aspects of identification, evaluation, approvals, and compliance monitoring related to related party transactions.

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Regulatory Requirements under Companies Act, 2013 and SEBI (LODR) Regulations

As per Section 134(5) of the The Companies Act, 2013, the Board of Directors are required to to state in the Directors’ Responsibility Statement that proper accounting policies have been selected and applied consistently and that judgments and estimates made are reasonable and prudent, ensuring a true and fair view of the company's affairs.

Meanwhile, Schedule IV of the Act requires independent directors of the company to satisfy themselves regarding the integrity of financial information and the robustness of financial controls and risk management systems.

Sections 177 and 188 of the Companies Act, 2013, and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, impose extensive responsibilities on audit committees and boards in relation to the review, approval, and disclosure of related party transactions.These include the requirement to receive prior audit committee approval of related party transactions, the establishment of policies for dealing with related parties, and specific disclosure obligations in the financial statements.

SEBI’s regulations further define material related party transactions and mandate shareholder approval for such transactions, with the additional requirement that related parties abstain from voting on resolutions concerning themselves.

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What is Ind AS?

Ind AS refers to Indian Accounting Standards, which are accounting principles notified by the Government of India to align Indian financial reporting with international practices. They are largely based on International Financial Reporting Standards (IFRS) and aim to ensure transparency, comparability, and reliability in the financial statements of Indian companies in accordance with global best practices.

What Financial Reporting Standards Require

Ind AS 24 prescribes the disclosure requirements for related party relationships and transactions. It recognizes that related party relationships are a normal feature of commerce and business and also highlights the influence that such relationships could have on the financial position and performance of an entity, even in the absence of transactions.

Ind AS 24 requires entities to disclose information about related party relationships, transactions, and outstanding balances, including commitments, to enable users of financial statements to understand the effect of such relationships. Furthermore, the definition of related parties under Ind AS 24 is detailed, covering both individuals and entities that have control, joint control, or significant influence over the reporting entity.

In instances where the Ind AS methodology is not applicable, the AS 18 shall provide the relevant disclosure requirements.

Both standards emphasize that disclosures should include the nature of relationships, amounts involved in transactions, outstanding balances, terms and conditions, guarantees given or received, provisions for doubtful debts, and expenses recognized on account of bad or doubtful debts due from related parties.

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What Standards on Auditing (SAs) Require

SA 550 addresses the auditor’s responsibilities relating to related party relationships and transactions. It emphasizes that related parties may give rise to higher risks of material misstatement due to the complexity and potential for collusion or concealment that may be inherent in such relationships.

Auditors are required to obtain an understanding of the entity’s related party relationships and transactions sufficient to assess whether the financial statements achieve a true and fair presentation and are free from material misstatement.

Auditors are also required to perform specific procedures such as inquiry of management about related parties, review of records and documents to identify related parties not previously disclosed, and evaluation of the business rationale behind significant related party transactions.

Auditors shall practice professional skepticism and remain alert to fraud risks throughout the audit and communicate significant matters regarding related parties to those charged with governance (TCWG), as part of their obligation under the Standards on Auditing.

Illustrative Questions for Audit Committees

Series 3 provides a detailed set of questions that audit committees may consider asking auditors to discharge their oversight responsibilities effectively. Some of them are:

1. Whether management’s understanding of the meaning of related parties is consistent with the definitions given in the Companies Act, Ind AS 24 or AS 18, SA 550, and the SEBI Regulations, 2015.

2. What inquiries were made by the auditor to management regarding the identity of related parties, the nature of relationships, and the type and purpose of transactions.

3. Whether the auditor considered related party transactions in light of the definitions in the SEBI Regulations, 2015.

4. What risk assessment procedures were performed to understand the management controls established for identifying, accounting for, and authorizing related party transactions.

5. Which audit procedures were performed to identify related party relationships and transactions, and whether the legal structure of the entire group was considered.

6. How the auditor verified that appropriate internal control processes have been established to identify any changes in group structure periodically.

7. How the auditor determined whether an entity or individual has control over the company, or vice versa.

8. Whether the management reviewed all shareholders’ agreements and relevant contracts to identify controlling relationships.

9. Whether the management obtained confirmations from promoters regarding their related entities and any changes therein.

10. How the management independently validated the information declared by directors or promoters.

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Conclusion

The NFRA Auditor-Audit Committee Interactions Series 3 is a significant step towards the continued practice of enhancing the quality of audits while promoting better corporate governance practices, particularly in the area of related party transactions and disclosures. The Series is a consistent endeavour by NFRA to apprise stakeholders of their roles and responsibilities in ensuring the completeness, accuracy, and integrity of financial reporting in relation to related parties.

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