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RBI Governor: Auditing challenges in financial sector

Address by Shri Shaktikanta Das, Governor, Reserve Bank of India at the National Academy of Audit and Accounts (NAAA), Shimla on October 25, 2021 is the motivation for this article. His speech is available in RBI website.

Though I have covered major part of his speech, enough input on the necessity of audit, the procedure to do it, and where we failed so far are also analyzed.

His speech started with the following introduction.

“Civil Services play a pivotal role in the overall progress of a country. They are the steel frame underlying the growth and development of our country. Within Civil Services, the Indian Audit and Accounts Service is responsible for auditing the accounts of the Union and State Governments and Public Sector Organisations.”

His later speech deals extensively with auditing and its role in financial sector.

  • The Pipe Rolls (collection of financial records) maintained by the British Exchequer were some of the earliest written financial records of the audit process of the monarchy’s accounts. The earliest surviving Pipe Roll at the National Archives of the United Kingdom covers the financial year 1129-1130.
  • Yes, some of the notorious scandals in railway companies in 19th century, forced the evolution of English Companies Act, 1845 which required semi-audit of company accounts by an audit committee of shareholders.
  • While many of us presume the evolution of audit an imported commodity, it is enlightening to hear that The Arthashastra written by Kautilya had prescribed detailed rules on accounting and auditing of public finances. The Arthashastra refers to “the collection and audit of all kinds of revenue” and goes on to say that “Accounts shall be submitted in the month of Ashádha ………Those accountants who do not present themselves in time or do not produce their account books along with the net revenue shall be fined ten times the amount due from them.” Ten times the due as the penalty!
  • While many of us are amused by the auding standards of us as the evolving one from the West, the above information may shackle our ignorance of our own history. Further developments like the Office of the Accountant General establishment in 1858, and the Indian Companies Act 1866 add to our knowledge.

Thereafter the honorable Governor of RBI touched the topic of the role of audit. Though I have included his observations below, I shall deal with auditing in a detailed manner at the end.

In his considered view:

  • Audit can be defined as an examination of the books of accounts and records of an enterprise to certify that the profit and loss account and the balance sheet are properly drawn up so that it exhibits a true and fair view of the financial state of affairs of the business.
  • In- accurate information in the absence of auditing may lead to wrong decisions at the hands of government authorities or other entities like banks, stakeholders like investors, creditors, suppliers, or buyers. Lack of audit standards have led to economic collapse as shown by great depression in 1933, or multitudes of financial scams in India since 1947. He quoted an example of a bank which can be applied in other situations as well. Diversion of banks’ funds has attracted the attention of many constitutional regularities.
  • In his view, Informative, accurate, reliable, and analytical audit reports are sine qua non for both financial stability and growth. The primary role of auditors is to resolve the Agency problems. Agency problems arise due to information asymmetries between the Agent (Management or the Government Departments/Users of Public Funds) and the Principal (Shareholders, Investors, and the Public).
  • He advocated that auditors should act as gatekeepers both for capital markets and for public funds used in business.
  • One will agree with his vision that the reports of the public sector auditors should facilitate better oversight, insight, and foresight.

In course of the lecture, he dealt in detail the role and Importance of the Institution of The Comptroller and Auditor General (CAG) of India. It is very useful to enhance our knowledge with his statement that the audit processes of the CAG through financial, compliance and performance audits of public institutions, do enhance the accountability and legitimacy levels for the use of public funds.

His later part of the speech did touch ‘Financial Sector Experience and Importance of Auditors.’ He elaborated that stability and growth of an economy and financial markets would be dependent upon trust among stakeholders and that one cannot take trust for granted. One does not deny that the auditors maintain public confidence in audited financial results of n banks, non-banking financial companies (NBFCs) and other financial entities.

RBI as the supervisor of banks and other NBFCs, keep a close watch on the role of auditors who while dealing with these entities  would ensure audit quality which as the first line of defence, verifies effective financial reporting of entities.

Did audit failures occur and how do they impact the system or entities involved?

Yes, too many failures did occur. He quoted how smart accounting practices of entities misled the stakeholders.

He drew attention to Ind-AS 109 with expected credit loss approach that allowed the management to use discretion and judgement in determining the provisioning requirements for financial assets. In his view, this resulted in ‘model risk,’ i.e., the model may rely on incorrect assumptions and may be far away from representing the real-life scenarios. This was observed in several cases. (One can easily corelate with the instances of less provisioning done in many leading public sector/private sector banking, leading NBFCs etc.)

He advised the auditors to test the models used by the entities, challenge the management, and validate the model outputs.

He exhorted the auditors to be tech savvy to be able to ‘see-through’ the layers of information technology to detect the real nature of hidden transactions.

Some of his other enlightening actions to be followed by auditors included:

  • Auditors to test the models used by the entities, challenge the management, and validate the model outputs.
  • There had been instances of diversion of funds and / or transfer of profits to connected parties through various means – intra-group loans on favorable terms, over or under invoicing of transactions, asset transfers without fair valuation, etc.
  • Auditors would need to identify and thoroughly scrutinize related or connected party transactions to ensure that no undue transfer of income or assets occur.
  • Auditors to verify the true nature of financial statements by studying misuse of transfer pricing by indulging in related party transactions by big entities through various layers of IT solutions.

Adopting technology tools such as Computer Assisted Audit Tools and Techniques (CAATTs) through constant upgradation and integration of new technologies will bring in a lot of efficiency in audits. In parallel, it must be kept in mind that adoption of such technology tools for auditing cannot replace professional judgment. A holistic approach would, therefore, be always required while integrating technology tools in audit.

Towards the last session of his talk, he narrated the following steps taken by RBI over the past few years to bring about improvement in the audit function in its Supervised Entities.

These steps included:

1. To have the confidence of all stakeholders, the financial statements of supervised entities of RBI were told to give full disclosures on the composition of regulatory capital.

2. To give details of the quality of advances with full provisions for movement in non-performing assets (NPAs).

3. Details of major complaints, full details on them, and the current position of their disposals are to be given in financial statements.

4. He mentioned issue of very important instructions such as revision of formats of Long Form Audit Report to increase its utility value, strengthening of Risk-based internal Audit system in Scheduled Commercial banks by issue of revised instructions in 2021, adoption of the same system gradually by large NBFCs and Urban co-operative banks, and updating the guidelines for Appointment of Statutory Auditors in Commercial Banks, UCBs and NBFCs putting in place ownership-neutral audit regulations for ensuring independence of auditors, avoiding conflict of interest in auditor appointments and improving the quality and standards of audit.

His conclusion was a clear message that Auditors would definitely need to update and upgrade skills on constant basis and perform their task in the most effective manner. His profile of tomorrow’s auditor would be one with a critical yet constructive challenging mind with a clear focus on public interest and quality audits.

Let me analyze the observations of the above learned speaker with a good textbook on auditing titled “Auding and Assurance Services” -an integrated approach by Alwin A. Arens, Randal J. Elder, and Mark Beasley all professors at various leading American universities. Reference given at the end.

How do they define auditing?

“Auditing the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between information and established criteria. Auditing should be done by a competent, independent person”

Many of you, reputed Chartered Accountants would confirm whether some of the steps quoted by me from the above text- book, any way tallies with our prescribed instructions on audit.

Since diversion of funds is the only auditing issue often talked about in recent discussions, let me quote only ‘audit sampling’ to know the facts.

Quoted from page 486 of the book* for our discussion.

“Decide whether audit sampling applies?

Audit sampling applies whenever the auditor plans to reach conclusions about a population based on a sample. The auditor should examine the audit program and select those audit procedures where audit sampling applies. To illustrate, assume the following partial audit program:

1. Review sales transactions for large and unusual amounts (analytical procedure)

2. Observe whether the duties of the accounts receivable clerk are separate from handling cash (test of control)

3. Examine a sample of duplicate sales invoices for a (credit approval by credit manager (test of control), b) existence of an attached shipping document (test of control), c) inclusion of a chart of accounts number (test of control).

4. Select a sample of shipping documents and trace each to related duplicate sales invoices (test of control).

5. Compare the quantity on each duplicate sales invoice with the quantity on related shipping documents (substantive test of transactions)”

6. The purpose of quoting from a textbook is to illustrate the necessity to understand words like test of control, substantive test of transactions etc. Yes, advanced credit-controlled accounting system have revolutionized the ease of doing business. But still, do the fundamental business way of doing ethical one has changed? Can transfer pricing be used to abnormally increase the amounts of purchases, sales, profit, or loss to suit Indian business entities of foreign holding companies and if so, what is the role of an auditor?

RBI Governor, one of the most respected bureaucrats then, and now, heading a big regulatory body needs no introduction to innovation, governance both at the central government where he served earlier or now at RBI.

Let us conclude that the simple looking sceptic auditor should conduct his auditing as per age old rules and regulations evolved over the ages but on a large scale due to the introduction of modern accounting systems totally based of computers and other advanced software like AI and others. Let the big accounting firms recruiting the youngest and the brightest teach the youngsters the rudiments of efficient working with ethical bias. The future of Indian advancement depends on honest working by all stakeholders and ably audited by brilliant auditors with a skeptic mind with the assistance of modern tools.


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