Auditor Cannot Rely On Undocumented OTS Proposal To Ignore Borrower's Interest Liability: NCLAT

The National Company Law Appellate Tribunal (NCLAT) in Delhi on Monday held that a proposed One-Time Settlement (OTS) with lenders cannot justify an auditor issuing a clean audit report by ignoring accrued interest on borrowings classified as non-performing assets (NPAs).

It ruled that an undocumented and unapproved OTS proposal cannot form the basis for derecognising a financial liability. "We are of the firm view that the OTS proposal that was never documented, never sanctioned by the bank's and never legally executed cannot serve as the basis for de-recognising a financial liability of interest," the tribunal held.

A bench of Judicial Member Justice Mohd Faiz Alam Khan and Technical Member Naresh Salecha dismissed appeals filed by chartered accountant Som Prakash Aggarwal, the engagement partner for the statutory audit of Vikas WSP Ltd. (VWL) for FY 2019-20, and his audit firm, S. Prakash Aggarwal & Co.

The appeals challenged orders of the National Financial Reporting Authority (NFRA) holding them guilty of professional misconduct. The tribunal upheld the ₹3 lakh penalty, three-year debarment, and mandatory training imposed on Aggarwal. It also upheld the ₹5 lakh penalty imposed on the audit firm.

VWL, a listed manufacturer and exporter of guar gum products, had borrowings of ₹135.65 crore as on March 31, 2020. By then, Punjab National Bank, Union Bank of India, and the Bank of India had all classified its accounts as NPAs. Even so, the company recognized finance costs of only ₹4.16 crore in FY 2019-20, compared with ₹21.08 crore in the previous year.

The tribunal noted that this understated interest costs by at least ₹16.91 crore. It also materially overstated the company's profit before tax. The proceedings were initiated after SEBI referred the matter to NFRA.

Aggarwal argued that there had been no concealment because the accounting treatment was disclosed in the notes to the financial statements. He contended that the anticipated OTS negotiations justified the non-recognition of interest. He also argued that shortcomings in audit documentation did not establish deficient audit performance.

According to him, the absence of an Engagement Quality Control Reviewer (EQCR) was only a lapse and not professional misconduct. He further submitted that the penalties were disproportionate. The audit firm argued that responsibility for the audit rested with the engagement partner and that proceedings against the firm amounted to double jeopardy.

NFRA, on the other hand, contended that the auditors failed to report material misstatements, accepted the company's accounting treatment without adequate corroboration, failed to maintain mandatory audit documentation, and ignored applicable auditing standards. It also argued that a proposed OTS could not extinguish an existing financial liability unless it had been legally concluded.

Rejecting those submissions, the tribunal held that RBI's prudential norms governing NPAs regulate only how banks recognise income. They do not extinguish a borrower's obligation to recognize interest in its own financial statements. The tribunal also held that Ind AS 109 permits derecognition of a financial liability only when it has been legally extinguished. An ongoing OTS proposal does not satisfy that requirement.

"We must understand categorically that 'legally released' requires an actual legal release i.e., a formally executed agreement, court order, or statutory operation. An ongoing OTS negotiation is none of these. The Appellants arguments that anticipated future OTS justifies non-recognition of current interest is, therefore, not only factually unsupported but legally impermissible under the standards of auditing," the tribunal observed.

The tribunal also rejected the argument that merely proposing an OTS could justify removing interest liabilities from the company's balance sheet.

"To accept the Appellants interpretation would be to introduce a back door through which any financially distressed company could eliminate its liabilities from its balance sheet simply by proposing OTS negotiations, without ever concluding them. This would render the entire framework of financial reporting meaningless," it observed.

Emphasising the wider consequences of audit failures, the tribunal observed, "For a listed company with thousands of public shareholders, institutional investors, and bank creditors relying on the audited financial statements, the audit is the primary safeguard against financial misrepresentation.When that safeguard fails, as it did here, the consequences extend far the company itself as it undermine public confidence in financial markets. In this backdrop, the Engagement Partner and the Firm bear a heightened responsibility to discharge their duties with utmost diligence and integrity so as to preserve and reinforce public confidence."

The tribunal found that the engagement partner failed to exercise professional skepticism despite the more than 80% fall in finance costs. It also found that he had not documented the basis for accepting the company's accounting treatment. Further, he failed to appoint an EQCR even though the audit related to a listed company.

The tribunal held that the absence of an EQCR removed an important safeguard in the audit process. It also rejected the firm's argument that it could not be held liable alongside the engagement partner.

"We are of very clear opinion and considered view that it is the firm which has to take higher responsibility and consequently higher obligations and consequences including penalties. By no stretch of imagination, the Appellant firm in present case, can separate itself from the conduct of the EP," the tribunal observed