NFRA's Scathing Rebuke Of Reliance Capital's Auditors Unveils Reckless Practices

Attributing "recklessness" and "unprofessionalism" on the part of Reliance Capital’s auditors, the National Financial Reporting Authority has imposed a penalty on the audit firm M/s Pathak HD and Associates, along with additional penalties on two individual auditors associated with the firm.

The firm, as the statutory auditor, and the partners who carried out the audit, did not conduct adequate due diligence and failed to report material misstatements in the financial statements of Reliance Capital Ltd., the NFRA said in its order.

Consequently, a penalty of Rs 3 crore has been imposed on the audit firm, along with additional penalties of Rs 1 crore and Rs 50 lakh on CA Piramal Kumar Jha and CA Vishal D Shah. In addition, Jha and Shah have been barred from engaging in auditing roles for 10 years and five years, respectively.

The order has been issued on the heels of multiple failures highlighted by Price Waterhouse & Co. LLP, including alleged irregularities and suspected fraud at Reliance Capital for FY19. PwC filed a complaint with the Ministry of Corporate Affairs after resigning as the firm's joint auditor due to a suspicion of fraud.

After resigning as the joint auditor for the firm, PwC informed PHD regarding financial lapses pertaining to irrecoverable loans and investments amounting to approximately Rs 12,571 crore made to group companies, which were portrayed as recoverable.

PwC had reported that the group companies had serious credit impairment and that many of these group companies used the money to invest in or lend to other group companies with similar credit impairment.

Despite this, PHD, in its audit report, did not raise any red flags. In contrast, it rationalised the actions of the company and ignored the fundamentals of accounting and auditing, NFRA’s order states.

The order further said that PHD and its auditors failed to comply with the established auditing standards as there was no evidence to show that they performed independent procedures on matters brought to their notice by PwC.

After PwC’s resignation as the joint auditor and its subsequent complaint to the government, the audit committee asked PHD to fully examine all the transactions referred to by PwC and provide their well-considered view to the committee.

In its report to the committee, PHD concluded that the transactions flagged by PwC did not merit a complaint as it could not find any instances of fraud in the company’s financials.

This report was then submitted to the board of directors, which in turn, obtained the views of legal experts to say that there was nothing to cast a doubt on the company’s financials.

However, the NFRA, in its order, states that the chain of events confirm that the audit committee’s conclusion was based solely on the auditor’s presentation to the committee, which was not subjected to the rigours of audit examination commensurate with fraud risk.

In addition, it states that the legal experts did not examine the merits of the transactions as pointed out by PwC as the auditors did not undertake an in-depth examination of the transactions.

The NFRA explained that once fraud is suspected and reported to the government, the legal determination of the fraud and admitting or ruling out fraud is a regulatory matter. “Neither the company nor the auditor is competent to make a conclusive legal determination of a statutory matter reported by the auditor,” it said.

It said that the normal course of action in this situation for any prudent company would be to initiate an independent investigation into the alleged matter to bring out the truth.

As a result, it ruled that the company and its board absolved themselves of their statutory duties and the auditors became an accomplice by displaying gross negligence of their statutory responsibility.

If a matter is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor shall include an Emphasis of Matter, or EoM, paragraph in the auditor’s report, provided that the auditor would not be required to modify the opinion regarding the matter that has been emphasised.

In the normal course of business, reporting fraud should normally form part of the EoM. According to the auditing standards, the event and an estimate of its financial impact or a statement that such an estimate cannot be made, should form part of the company’s financial statements based on which an EoM is issued.

However, since the company did not include the nature of the issues raised by PwC in its financial statements, the same did not feature in the EoM.

The NFRA stated that the issues raised by PwC were critical as they could’ve resulted in accounting adjustments such as write-off of the company’s assets due to the dubious nature of the loans granted, litigation expenses, compliance cost, loss of goodwill, action by lenders, etc.

In its report, PwC had highlighted the credit impairment of certain borrowing entities to whom loans were disbursed by Reliance Capital, which has a direct impact on the recoverability of the loans.

However, the auditor conducted no substantive audit procedure or adequate verification to rule out the non-recoverability of these loans nor was adequate provisioning done.

The NFRA, in its order, observed that of the 13 borrowing entities reported by PwC, under 11 entities were incurring losses and their net worth was completely eroded. These borrowing entities further invested the borrowed monies in similar entities having weaknesses like negative net worth, losses, etc, which posed a serious threat to the recoverability of all these loans, the order stated.

It also said that the auditor did not consider even a single case to document the ultimate utilisation of funds to understand the exact business purpose and the ultimate beneficiary of this web of multiple layers of transfer of money.

PHD and its auditors have been charged on various other counts as well. These include:

• No examination of the bank statements to rule out the possibility of evergreening of loans, despite the indications of circular transactions.

• The recoverability of loans to the tune of Rs 6,557 crore (net of impairment) disclosed in the financial statements was doubtful and hence, the management’s assertions of the value and rights of these loans were materially misstated in the financial statements, which PHD failed to report.

• Failure to obtain sufficient appropriate audit evidence regarding compliance with lending policy.

• No identification of fraud risk in revenue and management override of controls.

• Entire work relating to the audit of expected credit loss was grossly inadequate and the audit opinion issued was misleading.