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Mohan R. Lavi

Mohan R. Lavi on how the Indian accounting body can borrow a leaf from its British counterpart

EVER since the Enron and WorldCom fiascos, there has been an avalanche of legislation abroad ostensibly with the intent to prevent such occurrences. The Sarbanes Oxley Act, which resulted in the creation of the Public Company Accounting Oversight Board (PCAOB), started the trend. The PCAOB is formulating rules and regulations to regulate errant auditors. The European Commission, not to be left behind, formed the "Statutory Auditors' Independence in the EU — a set of fundamental principles".

Taking a cue from this, the Institute of Chartered Accountants in England and Wales (ICAEW) has issued a "Auditor Independence: Guidance on Best Practice". The purpose of the Guidance Note is to adopt the international best practices towards auditor independence. In India, although there is no definitive pronouncement towards independence, one can find sprinklings of them in various pronouncements of the myriad regulatory authorities.

The Guidance Note of the ICAEW starts off with a firm statement that rotation of auditors should be done at least once in five years — the ICAEW had previously recommended a period of seven years. The fundamental requirements of the independence is to assess and document, for each engagement, the actual or perceived threats to independence through self-interest, self-review, advocacy, familiarity and intimidation. In case safeguards cannot be taken to prevent these threats, the assignment should not be undertaken.

The applicability of the Guidance Note is to the audit firm, partners and other principals, persons directly involved in the audit engagement, audit managers and audit staff, professional personnel from other disciplines involved in the audit engagement, people providing quality control or direct oversight of the audit engagement and all other persons who form a chain of command for the audit.

References to closely connected individuals would extend to parents, siblings, dependants and regular social contacts too. So much of legislation is happening or about to happen that one gets the fear that this much of legislation would lead to leaving some stone unturned which would rock another boat. It would be impracticable to expect a taxation expert to be implicated for an accounting scandal. Similarly, why would the parents, siblings and regular social contacts transgress independence principles? The Guidance Note prescribes an outright embargo on holding of direct financial interests in the audit client or its affiliates.

Direct financial interests would encompass shares, bonds, notes, similar securities, derivatives, options and futures, and so on. Indirect financial interests, such as holding a significant investment in an entity in which the audit client too has a significant investment, are also taboo. In cases of persons proven of having any financial interest in the client, they should not serve on the audit engagement.

In cases where the staff of the audit firm know a person who holds a senior management position with the audit client, is in a position to exert direct influence on the preparation of the accounts, has a significant financial interest in the audit client or has a significant business relationship with the client, the audit firm should not take up the assignment. (As has been recommended by the Naresh Chandra Committee in India, in case any key audit principal intends to take an employment with the audit client, a period of two years should have elapsed since the conclusion of the relevant audit.) The Guidance Note goes on to say that it would be an unacceptable self-review threat, if the principal or employee of the audit firm who worked with an audit client under a staff secondment assignment were given audit responsibility for any function or activity that he was required to perform during the secondment assignment.

To prevent individuals being auditors of a company for a long period of time, the Guidance Note prescribes that the engagement partner is to be in charge of the assignment for not more than five consecutive years and he is not to return to the role till five years has passed. However, audit principals who rotate off the assignment can return after a two-year hiatus.

The Guidance Note details the non-audit services than an auditor can perform and the possible risks therein. In the case of valuation services, the Guidance Note states that there are no adequate safeguards available to counter the self-review threat that would arise from the provision of valuation services that would lead to the valuation of amounts that are directly material in relation to the financial statements being audited and where the valuation involves a significant degree of subjectivity. However, a small relief is provided to firms in that forming an opinion on the valuation work done by others and valuation services in the course of a due diligence are outside the purview of the Guidance Note.

Even in cases wherein the audit firm is called upon to provide design and implement financial information and technology systems (FITS), the Guidance Note throws the ball back in the court of the auditee by pronouncing that no threat arises if a) the management acknowledges that they take the responsibility for the system of internal control, b) the auditor is satisfied that the auditee is not relying on the FITS as the primary basis for testing internal controls, the design is set to specifications of the auditee and the FITS services do not constitute a turnkey project. Audit firms are permitted to provide accounting services to the client only in emergency situations. The Guidance rounds off by saying that the audit firm cannot provide services to the auditee that would involve resolution of litigation relating to matters that might reasonably be expected to have a material impact on the clients financial statements.

To an outsider, the Guidance Note would appear as though the auditor and the auditee are playing ping-pong to save their skin and expose the other. However, the fact remains that the financial statements are still primarily the responsibility of the management. It is only the duty of the auditor to express his opinion on the same. As a result, it all boils down to the integrity of the auditor. This is an individualistic trait that cannot be imposed. An auditor may be of the opinion that disclosing a bit of sensitive information on Page 64 of a 65-page annual report in Arial 8 font would suffice. With so much of the spotlights on the auditors, no one seems to be thinking of sitting on the other side of the table. Apart from making the CFO the signatory to the financial statements which they are doing already, there seems to be no other concrete guidelines.

It would be a worthy idea to evolve some sort of a code of conduct for the top management and certain designated employees. In case the concerned officers transgress the code of conduct, they are punished. In case they come out squeaky clean and the auditor has bypassed his independence, he is punished. It would be a travesty of justice to have numerous legislation for auditors when the source which precipitated this legislation, that is, auditees, do not act according to certain normal rules of the game.

The ICAI is yet to come out with its views on independence of auditors. It would be useful if they chose the best international practices and fine-tuned them to suit local conditions.

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