National Financial Reporting Authority (NFRA), which is the country’s sole independent audit regulator, has sought public comments — both from individuals and organizations — on its draft consultation paper of a new accounting standard by October 30, 2024. The proposed revision to SA 600 is intended to align it with the ISA 600, the corresponding international auditing standard already issued by the International Auditing and Assurance Standards Board (IAASB).
The National Financial Reporting Authority (NFRA) is proposing changes to how audits are conducted for companies with subsidiaries and associates. These changes focus on the consolidated financial statements that companies present. The accounting regulator aims to enhance the accountability of the principal auditor responsible for the company holding stakes in these entities. To this end, NFRA has released a draft of a new accounting standard, addressing the reliance on the work of other auditors. This topic is of significant importance to investors.
The NFRA has released a long-anticipated consultation paper proposing revisions to a key auditing standard, SA 600 (Using the Work of Another Auditor), aimed at addressing shortcomings in group audits. This decision to update the two-decade-old SA 600 stems from NFRA’s findings of significant deficiencies in the audits of Public Interest Entities (PIEs). The authority observed that many audit firms and auditors demonstrated an inadequate understanding of their legal obligations and improperly applied the SA 600 standard, both as principal and other auditors. The NFRA’s investigations, including both government-referred cases and suo-motu inquiries, have uncovered significant negligence and a serious lack of due diligence among auditors. This has negatively impacted the interests of stakeholders in PIEs.
NFRA, which is the country’s sole independent audit regulator, has now sought public comments — both from individuals and organizations — on the consultation paper by October 30, 2024. The proposed revision to SA 600 is intended to align it with the ISA 600, the corresponding international auditing standard already issued by the International Auditing and Assurance Standards Board (IAASB). In the consultation paper, NFRA made mooted changes to empower the principal auditor to access the working papers of the audit of component auditors. It also wants principal auditors to own up to the actions of the component auditors instead of just relying on them.
The Proposed Revisions
The proposed revisions outlined in the NFRA consultation paper aim to significantly enhance the protection of various stakeholders, including retail and institutional investors, creditors (such as banks and other financial entities), and foreign investors. One of the key areas addressed in the paper is the application of Standard on Auditing (SA) 600, which is relevant for auditing companies that have subsidiaries and associates.
Under SA 600, the audit process typically involves a principal auditor responsible for the holding company, while other auditors, referred to as component auditors, handle the audits of subsidiaries and associates. This standard delineates the respective responsibilities of both the principal auditor and the component auditors, ensuring clarity in the audit process. The consultation paper suggests important changes aimed at reinforcing the accountability of the principal auditor. Specifically, it proposes that the principal auditor should not only oversee the audit of the holding company but also take full responsibility for the actions and judgments made by the component auditors auditing the subsidiaries. This shift emphasizes the need for a cohesive approach to auditing within corporate groups, where the principal auditor is held accountable for the overall audit quality and the reliability of financial statements across the entire group.
By implementing these revisions, the NFRA aims to strengthen the integrity of the auditing process, thereby fostering greater confidence among investors and creditors in the financial reporting of corporate groups. This enhanced accountability structure is expected to lead to more thorough audits, ultimately protecting the interests of all stakeholders involved.
Investor-Friendly Initiative
Consolidated accounts have become the standard in financial reporting, and over the years, investors have embraced this approach, gradually overcoming their initial reluctance to shift their perspective from standalone company valuations. Today, except for a few instances where standalone figures dominate—often comprising over 90% of the total—consolidated financial statements are prevalent in the analyses conducted by market participants. In consolidated financial statements, the financial results of subsidiaries—where the parent company holds more than a 50% stake or has significant influence—are combined with those of the parent company. This integration allows for a comprehensive view of the overall financial health of the corporate group. Importantly, the portion of profits attributable to minority shareholders, who own stakes in these subsidiaries but do not control them, is deducted from the consolidated profits to accurately reflect the earnings available to the parent company’s shareholders.
Additionally, when it comes to associated companies, which are typically those where the parent holds a significant but non-controlling interest (usually between 20% and 50%), a proportionate share of their profits or losses is included in the consolidated financials. This method provides a clearer picture of the parent company’s financial performance, encompassing the contributions and risks associated with its investments in both subsidiaries and associates. Overall, this comprehensive approach to financial reporting offers investors a more nuanced understanding of a company’s value and operations in the context of its entire corporate structure.
The rationale provided by the NFRA included as a note with the draft and open for public feedback, argues that the main auditor should have enhanced oversight of group audits. It highlights specific instances of fraud and other issues detected in subsidiaries that ultimately impacted the holding company. To underscore the significance of this topic, the rationale examines the top 100 listed large and mid-cap companies as a case study.
Many companies operate through a substantial number of subsidiaries, joint ventures, and associates. Notably, 23 of these companies have more than 50 such entities, while 76 have international components. Additionally, a significant portion of net assets is derived from these components: in 20 companies, over 50% of net assets come from them. Furthermore, for 17 companies, more than 50% of the revenue is audited by the auditors of these components. This indicates that the audited results of the components are essential for the overall audit of the parent company holding stakes in them.
The NFRA aims to address the current practice where auditors of the main holding company often rely solely on the reviews or reports provided by the auditors of component companies. Their conclusions regarding the amounts and disclosures for these components are typically based entirely on the other auditor’s report. The NFRA seeks to update these standards to align with international practices and lessons learned from adverse experiences in some cases. The ultimate goal is to enhance public interest and foster greater trust in the auditing process.
Key Areas NFRA Draft Proposes Changes
Without delving into the specifics, here are several key areas where the NFRA draft proposes changes. One significant focus is the principal auditor’s level of responsibility and their reliance on the work of component auditors. While principal auditors are ultimately accountable for the work of other auditors, the existing exceptions allow for considerable discretion. It has led to situations where, even when component auditors report issues such as fraud or concerns regarding going concern, principal auditors have sought to shield themselves behind these provisions. Another important aspect is the assessment of the professional competence of component auditors and the sharing of work papers—critical documents that auditors rely on to formulate their reports.
The current standards were established in 2002 and do not account for updates to international standards made in 2009 and 2023. The outcome of this review process remains to be seen. The NFRA note addresses counterarguments concerning issues like the concentration of work among a limited number of firms and potential negative impacts on small and medium-sized CA firms, responding to these concerns. From an investor’s perspective, any reform that enhances trust in financial statements and aids in making informed investment decisions should be welcomed, and this proposal should be no exception.
