The bank audit extravagance

The new president of the Institute of Chartered Accountants of India (ICAI), M Devaraja Reddy, recently said that the system of appointment of bank auditors is to blame for the problem of rising non-performing assets (NPA) and low audit quality. He proposed a three-point solution:

1. The Reserve Bank of India or the Comptroller and Auditor-General of India should appoint bank auditors.

2. Banks should have multiple auditors instead of one or two.

3. Banks should do more branch audits.

The ICAI president was being either naïve or disingenuous. But I thank him for starting an important debate.

Auditor appointment Central auditors and branch auditors of public sector banks (PSBs) are appointed by an elaborate process that involves the ICAI, the CAG, the RBI and the banks’ audit committees.

Private banks’ shareholders appoint their auditors according to the Companies Act. In no case does a bank’s chairman or executive management appoint the auditors.

The government has allowed PSBs to appoint their auditors as part of its plan for giving them greater functional autonomy. Aspirants apply to the ICAI, which verifies the information and sends the names to the CAG. After further scrutiny, the CAG sends the names to the RBI.

The central bank forwards the names of eligible CAs to the PSBs, which have to select CA firms taking into consideration their size, experience, reputation and geographical proximity.

The bank’s audit committee takes the RBI’s prior approval for appointment. After that, the bank appoints. Hundreds of private banks, thousands of non-government companies and millions of proprietary and partnership businesses in India select their auditors. Do these organisations also have audit quality issues?

There is a bizarre rule that 60 per cent of a PSB’s central auditors must have prior central audit experience and the remaining 40 per cent must not have such experience (You read it right.) No one in their senses will appoint inexperienced electricians, cooks or drivers. Then why should PSBs be compelled to appoint inexperienced auditors?

Multiple auditors The ICAI president says that by reducing the number of audit firms to one or two, banks are deprived of the “collective wisdom” of a legion of auditors. It is unclear how adding more auditors can lead to better audit quality. Views differ on whether joint audits improve or impair audit quality.

One view is since “two heads are better than one”, audit evidence precision improves in joint audit. In the best case, joint auditors act as mutual monitors. The opposite view is that some joint auditors may enjoy a free ride on the others.

This could mean, for instance, that some of them may overlook an issue hoping that the others would take care of it. There is a serious risk of issues slipping through the cracks. In 2014-15, State Bank of India had 14 central auditors; Bank of Baroda and Punjab National Bank had six each; other PSBs too have multiple auditors. Having so many auditors is a nightmare for bank boards. In contrast, large private banks and most companies have just one auditor. Do they have audit quality issues?

Audit coverage The ICAI president’s demand for more branch audits gives the impression that the current audit coverage in PSBs is inadequate. The fact is PSBs are already subjected to a lot more external auditing compared to private banks. PSBs have year-end branch audits and year-round concurrent audits by external auditors.

Branch auditors, along with central auditors, are responsible for ensuring proper asset quality classification and adequate provisioning for NPAs. Concurrent auditors are expected to verify loan transactions and documents in branches. They are in the best position to detect and report many kinds of frauds.

As is widely known, the recent leap in NPAs is partly due to the late recognition of loan losses. Bank frauds have been rising. How does this happen when armies of external auditors are scrutinising banks?

With central data and document processing systems, branches are only executing transactions and entering data. Under core banking solution, the central office keeps branch accounts. With branches no longer doing accounting locally, branch audit has become redundant.

An equally strong case exists for discontinuing concurrent audits. These are legacies from the days of manual accounting and documentation. Intriguingly, large-scale external branch audits are only for PSBs. In private banks the statutory auditors audit just a few branches. Chart 1 presents the position on branch audits in three large private banks.

In contrast, branch audit coverage in PSBs is around 50 per cent. As a result, PSBs spend a lot more on auditing. Chart 2 presents information about auditors’ fees and expenses of large PSBs and private banks.

Curiously, the Banking Companies (Acquisition and Transfer of Undertakings) Acts of 1970 and 1980 have no requirement for branch audits. It merely requires the central auditor to report “whether or not the returns received from the offices and branches of the corresponding new bank have been found adequate for the purpose of his audit”.

In contrast, the Companies Acts of 2013 and 1956 require branch audits. Can there be a better example of irony?

Who benefits? PSB boards have CA directors nominated by the government. Also, CAs certify the financial statements of bank borrowers and help them get bank loans. With CAs everywhere in the banking system, it is time to ask questions about their role in preventing, detecting and reporting bad loans and frauds.

Did the bank auditors notice any red flags in the boom years? Did they insist on adequate and timely NPA provisions? Did they warn the banks’ shareholders and depositors about weaknesses in internal controls? In short, where were the auditors? Even if the CAG or the RBI appoints the auditors, the same individuals will do the work.

The ICAI president’s proposal to centralize auditor appointments will lead to lobbying and corruption. Many good firms will withdraw from bank audits and the market will be left with the wrong ones in a replay of the ‘lemons problem’.

Rising bad loans has serious economic and political repercussions. The accounting industry should work with the banks, the RBI and the government on enhancing audit quality in order to regain the society’s faith in auditing.

The writer is a professor of finance and accounting in IIM-Bangalore. The views are personal

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