Bringing accountants to account

The Companies Act 2013 provides for setting up a National Financial Reporting Authority (NFRA). The recent report of Parliament’s standing committee on finance on the Companies (Amendment) Bill 2016 has reopened what appeared to be the settled position on auditor regulation.

NFRA has a larger remit than NACAS (National Advisory Committee on Accounting Standards), which it is meant to replace. NACAS only recommends accounting standards. NFRA will set accounting and auditing standards, monitor and enforce compliance with the standards, and oversee the accounting profession’s record of ensuring compliance. It will take away significant regulatory powers from the Institute of Chartered Accountants of India (ICAI).

Self-regulation works only up to a point. Society expects that the professions will police themselves effectively. After all, deviant conduct damages the reputation of an entire community, so there is incentive to punish the bad guys. There is a lot to commend in this market-based argument. Unfortunately, the market fails quickly in a self-regulatory mechanism because of the inherent conflicts. An individual member engaging in aberrant conduct is unlikely to be deterred unless the punishment is swift and appropriate.

Neither is probable because the members elect representatives who decide whom to punish and what the punishment should be. It is no longer the well-intentioned mechanism at work. The political process takes over and there will inevitably be compromises. Externalities ensure that the members do what is good for them individually rather than for the whole community. Market failures like these have to be dealt with by external regulation, as in the case of pollution control.

More importantly, self-regulation hurts those outside the accounting community. Investors and lenders are often victims of dodgy accounting and incompetent auditing. They would have no confidence in the fairness of the process when their complaints are heard by other accountants. To them it is a clubby world. For this reason, many who have suffered at the hands of accountants are unlikely to have even complained to the ICAI. So the relatively low number of complaints does not mean that all is well. In fact,the opposite is likely.

That is why in most countries outsiders oversee the work of accountants. The Public Company Accounting Oversight Board (PCAOB) in the US and the Financial Reporting Council (FRC) in the UK are examples of effective outside regulation. Surprisingly, the ICAI and its members will be the biggest beneficiaries of external regulation. When there is greater assurance that improper conduct will be punished, the value of the ICAI’s franchise will go up. Scrupulous members can apply stricter accounting and auditing requirements and be more forthright in expressing disagreement. They don’t have to fear losing clientele. They can expect to be paid more for being strict. They can invest more in training and technology and pay their employees better. Eventually, inferior firms will drop out of the audit market. Overall, it will be a better outcome for the accounting community.

The ICAI can facilitate NFRA’s work by training expert witnesses who can provide independent opinion in disciplinary cases. Also, it will be able to pay more attention to educating and training current and future members. The rising challenges of technology require single-minded attention to skill development. Accounting is one of the professions most threatened by automation. In a speech to the Trade Unions Congress in 2015, Andy Haldane, the Bank of England’s chief economist, said that chances of accountants being replaced are “a whopping 95 per cent”. Outsourcing regulation will free resources for the ICAI to work on developing new and complex skills needed in the uncertain world of technology.

NFRA can enhance investor protection by effective oversight of accounting and auditing. It will fill a critical gap in the current arrangements by enforcing compliance with standards. Dumping NFRA will be a clear case of regulatory capture by the accounting industry.

The writer is a professor at IIM-Bangalore. The views are personal

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