And then they were three

R. Narayanaswamy | Updated on January 16, 2018 Published on January 11, 2018

Zooming in: On fudge deals   -  iStockphoto

SEBI’s ban on the Price Waterhouse group from auditing companies for two years will alter the audit scene considerably

We are not talking here of the 1970s album by the rock band, Genesis. On January 10, the Securities and Exchange Board of India (SEBI) banned Price Waterhouse and group firms from auditing listed companies in India for two years for failing to detect the Satyam Computers accounting fraud. The firm has said it will appeal the order.

The United States Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) have already fined Price Waterhouse firms in India a total of $7.5 million, the largest against any registered foreign accounting firm. SEBI’s order comes nine years after the Satyam chairman, Ramalinga Raju, confessed to inflating the company’s cash and bank balances, trade receivables, revenue and profit running into billions of rupees. The revelation shook the stock markets and faith in Indian companies’ financial reporting and governance. Satyam has become a byword for accounting fraud, joining Enron, WorldCom and others.

Change factor

SEBI’s order will alter the audit scene in India fundamentally. The Big Four will now become just the Big Three: Deloitte, EY, and KPMG.

What does this imply? First, this is likely to be the beginning of the end of Price Waterhouse group’s (including PricewaterhouseCoopers) audit practice in India. In the coming fiscal year, clients will go to other auditors; they may not be keen to return to Price Waterhouse when the ban ends. With audit revenue becoming a small fraction of what it is now, it would be uneconomical for the Price Waterhouse group to keep its audit divisions going. Besides, faced with significant uncertainty, most of its staff will leave for other firms. There seems no prospect of a comeback for Price Waterhouse India, at least in auditing.

The firm faced a similar situation in Japan when its Japanese unit Chuo Aoyama was suspended for two months from auditing following the accounting scandal in Kanebo. It is yet to regain its lost glory in that country.

Second, auditor choice becomes even more narrow for bigger listed companies. Though companies can appoint any CA firm to audit them, size matters. Bigger audit firms have larger and superior human and technical resources and deep pockets, just in case things go wrong. Investors also have more comfort when the auditor is a large firm, because the auditor can presumably resist client pressure.

The Big Four operate in many countries and are more acceptable to regulators. Large listed companies in India will now have only three big firms to choose from. This will increase concentration in the audit industry and could raise the scarcity premium, and hence audit fees, for the three firms.

Third, the reduction of the Big Four to the Big Three heightens risks for clients and investors. If a Big Three firm were to be caught in a scandal and is banned, or it collapses (as did Arthur Andersen), there will be just two of the Big Four firms in India. Industry concentration will increase even further and the premium will go up even more for clients and investors.

Indian regulators would want to avoid such a situation and may be reluctant to act tough against the Big Three. With no incentives to improve service quality and no fear of the regulator coming down on them for deficient work, the Big Three may do little to improve their performance standards and may become less sensitive to criticism of their work. Ironically, the punishing of Price Waterhouse could end up lowering rather than enhancing audit quality.

Exit implications

Is the exit of Price Waterhouse good for the non-Big Four in India? Unlikely. Indian firms don’t have an international presence; few are present in more than one or two States. Clients used to having the stamp of a Big Four firm on their financial statements are unlikely to be comfortable with local firms. Foreign private equity and venture capital investors and joint venture partners are not about to run to Indian firms.

Even so, this is a great opportunity for Indian firms to grow and go global. To begin with, mid-sized Indian firms should come together through mergers and acquisitions and form large firms with a national presence. Over time, they can extend their activities to other countries. For this they should become truly professional and abandon viewing their business as family property. Increasing competition in auditing is good for clients, investors and regulators. Indian businesses are doing well in software, pharmaceuticals and entertainment. There is no reason why Indian accountants can’t repeat those success stories.

Price Waterhouse’s troubles are sure to raise questions about the meaning of a Big Four affiliation. Are the Big Four firms loosely affiliated local entities, or are they multinational corporations the way Microsoft, General Electric and IBM are? If it is the former, are clients justified in assuming that they have identical standards worldwide? If it is the latter, will their overseas owners take responsibility for their local operations?

Audit firms, especially the bigger ones, need to re-examine the way they govern themselves internally. They should consider having a supervisory board that includes independent experts. The board should ask questions about the firms’ policies and practices in audit quality, risk and independence. In the highly competitive world of auditing where the pressure to get business often takes precedence over the need to remain sceptical, outsiders can take a dispassionate look at what goes on inside these firms.

Not the last

Satyam is not the first accounting fraud, nor will it be the last. The Government should set up the proposed National Financial Reporting Authority (NFRA) without further delay. It should have high-quality, well-paid independent experts. An effective NFRA can prevent, detect and punish corporate accounting and auditing failures.

The writer is a professor of finance and accounting, Indian Institute of Management-Bangalore. The views are personal

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Published on January 11, 2018
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