The dubious record of global audit firms

Whenever corporate accidents such as IL&FS occur, an inevitable discussion follows on the role of both statutory as well as internal auditors. Since they are privy to a lot of information during the course of their audits, there is a consensus of opinion that their audit reports should be able to tell things as they are.

Unfortunately, audit reports in India are structured with a lot of disclaimers and worded so cautiously that the shareholder will not be able to form an opinion whether the financial statements present the actual picture of the company. For instance, in the IL&FS audit report, the auditor has drawn attention to the fact that a subsidiary of IL&FS has incurred large losses which could impact the continuance of the subsidiary as a going concern. However, this paragraph does not name the subsidiary nor the extent of losses —both of which are camouflaged in a Note on Page 316 of a 334-page document.

The auditors may claim that the issue at IL&FS was a case of cash flow mismanagement — which is not a part of their scope of audit. Critics of the auditors reject this by stating that the concept of true and fair and going concern would include basic concepts such as cash flow mismanagement. Such a discussion leads to the question whether the auditors are getting too cosy with the management, which leads to the issue of whether too few auditors are doing too many audits.

Regulators have always frowned upon monopolies — whether as a single entity or a collection of entities. In the world of auditing, the ‘Big Four’ have always dominated the audit of listed entities.

Auditors and Carillion

A discussion on whether too few auditors are doing too many audits is already taking place in the UK. A need for this discussion arose after Carillion — one of UK’s leading construction companies — filed for bankruptcy early in 2018. Carillion and IL&FS had at least two similarities — they were in an industry which is prone to high risk and both had accumulated large amounts of debt.

When Enron happened, the US reacted with the Sarbanes Oxley Act. After Carillion happened, the House of Commons established a Committee to probe into what happened and to also suggest possible solutions. The Committee came out with a scathing report which stated that Carillion’s accounts were systematically manipulated to make optimistic assessments of revenue, in defiance of internal controls. One audit firm was paid £29 million to act as Carillion’s auditor for 19 years. It did not once qualify its audit opinion, complacently signing off the directors’ increasingly fantastical figures. In failing to exercise professional scepticism towards Carillion’s accounting judgments over the course of its tenure as Carillion’s auditor, this audit firm was complicit in them. Carillion paid other big-name firms as badges of credibility in return for lucrative fees. Another audit firm, paid over £10 million by the company to act as its internal auditor, failed in its risk management and financial controls role. A third one was paid £10.8 million for six months of failed turnaround advice. During the cross-examination of the audit firm, a Member of Parliament told the partners of one audit firm that he would not hire them to do an audit of his fridge, because when he reads the audit report, he will not be able to decipher what is in his fridge and what is not.

The Committee concluded that there is a danger of a crisis of confidence in the audit profession as Carillion was not an isolated failure, but symptomatic of a market which works for these audit firms but fails the wider economy and there are conflicts of interest at every turn. The Committee recommended that the government refers the statutory audit market to the Competition and Markets Authority.

The terms of reference of that review should explicitly include consideration of both breaking up the Big Four into more audit firms, and detaching audit arms from those providing other professional services. Unsurprisingly, the audit firms have responded by stating that breaking their domination is no solution. As an alternative, they suggest that there could have a system of joint audits or they could lend their staff to smaller firms.

In most markets including India, the Big 4 auditing firms dominate the cream of audits. The system of rotation of auditors introduced by the Companies Act, 2013 has not helped smaller firms because most of the audits rotated within the Big 4 accounting firms. Since most of these firms have similar cultures, swapping the firms doing the audit may not bring fresh perspectives to audits since the individuals invariably rotate within the Big 4.

In the present day, auditors should don the role of a devil’sadvocate. If this is combined with a truly independent audit committee, corporate shocks such as IL&FS can be handled much more professionally.

Rating auditors

In most countries, the format of the audit report was amended recently asking the auditor to comment on key audit matters. This too has not helped because the response of the auditor to the key audit matter gives nothing away in terms of what could be wrong. One possible solution could be to ask auditors specific questions such as possibility of fraud, ability to repay loans, tone at the top for ethics, robustness of internal controls and corporate governance processes. Their responses should be either Yes or No or rated on a scale of 1 to 10.

Since the auditor is putting his neck on the line, he may just take that much more care in assigning a rating or confirming ‘Yes’ or ‘No’. In turn, the audit firms should be rated based on how their ratings panned out. If companies are given the freedom to choose their auditors, they would naturally choose ones with the best ratings, irrespective of whether they are a part of the Big 4 or the Smallest 40.

An audit should provide value-added information to the shareholder instead of telling him that everything is fine till someone other than the auditor discovers otherwise.

The writer is an independent chartered accountant.

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