Regulator tells auditors to scrutinize loans that are used to divert company funds

The regulator’s warning has gone out to both auditors and the audit committees of businesses led by independent directors. These may be a case of professional incompetence or auditors lowering their guards and failing to question management’s approach and assertions, experts said. 

Experts said the NFRA’s latest note on recognizing credit losses by companies will prompt auditors and audit committees to scrutinize whether companies are creating a smokescreen around how they deal with loans given to related parties and how losses on that count are shown on their books. 

Audit committees are specialized committees of the board of directors in a company, tasked with overseeing financial reporting and the audit process.

NFRA’s past investigations including of certain non-bank lenders had identified fund diversion from companies through subsidiaries and associates by way of loans given to them, the regulator had said last October while listing its findings from multiple probes for the benefit of auditors and companies.

In a note released by NFRA earlier this month, the watchdog spelt out the questions auditors should expect from audit committees on how credit loss is accounted for and audited. 

NFRA had last October cited scandal hit Dewan Housing and Finance Ltd. and IL&FS which collapsed with a debt of ₹ 90,000 crores, in a circular that spoke about audit failures to detect fund diversion through subsidiaries and associates.

Illustrative questions

In a set of illustrative questions, NFRA said, “Has the auditor observed any loans, advances or receivables from the related parties (including promoters or promoters related entities)? If yes, has the auditor verified the business rationale of such transactions or creditworthiness of such entities?” 

The guidance comes as the financial year draw to a close – after which businesses have six months in which to hold annual general meetings and one month from the date of that meeting to file their financial statements with the registrar of companies. 

That leaves ample time for these questions to be asked about the FY25 accounts.

“Effective oversight by strong, active, knowledgeable, and independent audit committees significantly furthers the common goal of auditors and audit committee in providing high-quality, reliable financial information to the capital markets and securing public interest,” said Vishal Divadkar, partner & head – audit and assurance, M S K A & Associates.

“Considering the ensuing quarter and year endings, the timing is opportune for auditors, audit committees and the management to have an open discussion,” said Divadkar. Periodic papers on key auditing topics are a welcome initiative by NFRA and would strengthen the financial reporting framework and governance practices in corporate India, he said.

Committees must question

The regulator also expects audit committees to question the auditor on whether they have evaluated the management assessment of credit risk or whether there is complete reliance on the management’s judgment. 

NFRA’s move seeks to make sure the gatekeepers of corporate governance—auditors, audit committees, boards of directors and key managerial persons in the company—take their fiduciary role seriously. NFRA’s mandate covers both auditors and the preparers of financial statements of public interest entities including listed companies, banks and insurers.  

Experts pointed out that auditors and audit panels will not be able to ignore the suggestions from NFRA, although these suggestions have come in a publication as part of NFRA’s advocacy efforts.