Mohan Lavi

Audit reform proposals are unrealistic

Mohan R Lavi | Updated on March 13, 2020

Soften the blow The threats to audit independence can only be minimised, not completely removed istockphoto   -  baloon111

The MCA paper on the subject is well intentioned in its efforts to curb Big 4 dominance. But additional steps are needed

Ever since the Enron scandal, regulators across the world have embarked on various missions to attempt and regulate auditors. The US reacted to Enron with the Sarbanes-Oxley Act and the UK formed a committee to deliberate on independence of auditors. India reacted to the Satyam and Sahara episodes by passing a Companies Act in 2013, which used the words “ penalty” and “ imprisonment” more frequently than the word “ company”.

Still, auditing failures continued to occur — the Carillion episode in the UK and the IL&FS case in India are glaring examples. The last financial year saw auditors voluntarily giving up audits that they had being doing for ages.

Perhaps as a reaction to the IL&FS, PMC Bank and DHFL imbroglios, the Ministry of Corporate Affairs has decided to attempt further regulation on the auditing profession by issuing a consultation paper to examine existing provisions and make suitable amendments to enhance auditors’ independence and accountability.

Eliminating threats

The consultation paper seeks to take many actions to remove threats to auditors. To remove the self-interest threat, it recommends prohibition of providing non-audit services, fees based on reasonable estimates of time and expertise required, stringent independence guidelines and monitoring by firms, disclosure of previous business relationship with the company in the audit report and legislative restrictions on auditors’ independence.

To remove the self-review threat, the ideas that the MCA has come up with are stringent quality review procedures within firms, prohibition of retired partners joining clients within the cooling period, confidentiality of information, prohibition of personal relationships with clients and of providing certain assurance engagements for the client.

The advocacy threat is sought to be removed by prohibition of business relationships, strict rules on promoting clients and rotation of audit partners. To remove the familiarity threat, it is suggested that there should be a restriction on personal relationships, rotation of audit partners and possibly senior auditors and disclosure of commission and other relationships. To remove the intimidation threat, it is proposed that the appointment of auditors be undertaken by external authorities, such as the CAG.

Idealistic measures

The intention of the MCA is theoretically ideal, but practically impossible to implement. None of these threats can be removed; they can, at best, be minimised. Quite a few of these suggestions — such as a list of non-audit services that cannot be provided to clients, rotation of auditors and quality review procedures — are already in place, though their impact has been limited.

The paper is also a tad overoptimistic in suggesting bizarre plans such as prohibition on personal relationships/business relationships, without really defining what they are. The Companies Act, 2013 did bring in a rule on rotation of audit firms once in five/10 years. Rotation did take place, but largely amongst the leading accounting firms — known as the ‘Big Four’. The CAG and RBI do maintain a panel of auditors to whom audits are given out. The circle will be complete if SEBI maintains such a panel for listed entities and the IRDA maintains one for insurance companies. However, there will be confusion as to who should appoint the auditor of a listed insurance company — this can be solved by mandating that anything on insurance would be the prerogative of the IRDA.

It is a fact of life that so long as the audit fees are paid by the client, no auditor can be truly independent. Instead of multiple agencies maintaining a panel of auditors, the National Financial Reporting Authority — or even a special purpose entity under it — should be mandated to maintain an audit panel for all listed companies and an audit fee fund to which contributions will be received from all listed companies; for instance, the fees they paid in the previous year can be their contribution. The fund would then pay the fee to the auditors every year. Recommendations on whom the audit should be allotted to can be taken from the respective regulators.

The Big Four

Another part of the consultation paper targets the Big Four accounting firms, and asks questions in a bid to regulate them and distribute audit assignments amongst a wider population of audit firms.

The questions are along the lines of determining the way out to remove such economic concentration of audit; the possibility of reducing the number of audits under one audit firm/auditor; reducing or fixing the number of partners under one audit firm; and easing the burden on these Big Four. It asks whether “other audit firms in India are able to compete with them and reduce the workload of Big-4”.

Methods to reduce the dominance of the Big Four have been discussed to death in various geographies all over the world. The fact that they are a network of a bunch of firms under a common banner makes it difficult to charge them with monopolising the audit market.

Yet, there can be no doubt that if given an opportunity, smaller firms in India can match their work in terms of quality. The threat of the Big Four can be minimised only if around 15-20 companies outside the network join together. Mandating joint audits could be a possible solution, provided the auditors do not point fingers at each other when uncomfortable questions are asked on the audit.

A detailed look at the consultation paper leaves one with the impression that the MCA has attempted to do too much in too little a time. It proposes an audit quality index which once again sounds awesome initially. However, what would go into this index and how this could apply to a profession such as auditing, which thrives on judgment, could prove to be dampeners.

One of the ways to minimise the threats to auditors is to immediately punish those erring — not only through monetary penalties but also actions such as blacklisting and banning firms. Insurance firms should be encouraged to increase coverage for all audit risks, so there is something in the game for auditors too.

The writer is a chartered accountant

Published on March 13, 2020

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