The many ways of improving audit quality

M Damodaran | Updated on June 21, 2021

The trust factor Distrust in the audit process can seriously impede coroprate governance   -  /iStockphoto

Regulators and auditors must be on the same page to protect the interests of investors. Boards too must be held to account

Where were you when the lights were going out? This is a question that is asked of different sets of persons in responsible positions when a corporate entity gets into a state of terminal decline. At different points of time, Boards, Independent Directors, Regulators and auditors have been the principal accused in this trial. Responsibility can, and must be, apportioned, and be laid at the doorsteps of all these persons/organisations.

Our present focus is on audit quality as a mechanism that is both preventive and curative in addressing impending corporate failures. Several suggestions, bordering on solutions, emerged at a recent roundtable hosted by Excellence Enablers Private Limited, a niche Corporate Governance advisory firm, regarding the steps to be taken to improve the quality of audit.

Quality of audit would, among other things, depend on capacity building, especially of medium and small auditing firms, which aspire to be auditors of more and bigger companies, a space which they point out has been monopolised by the Big 4 accounting firms. Without capacity building, distributive justice, by way of handing out audits, including joint audits, to a larger number of audit firms, could be counterproductive.

Managements readily concede that they are a part of the problem when it comes to unacceptable audit quality. In not making correct and complete financial statements available to auditors in time, and in compressing the time available to auditors, in order to ensure that the company is among the first to declare its results, managements are often the initial source of the problem.

Internal auditors, especially those who belong to the corporate entity, have a major role to ensure substantive and procedural rigour. This will necessitate independence of the Internal Audit function, and a clear and direct reporting relationship to the Audit Committee (AC), and the absence of dotted line relationships which can adversely impact independence.

Conscience keepers

ACs are, in a sense, the conscience keepers in the companies, and it is to them that shareholders, and other stakeholders, look up to, to ensure that there is no disconnect between the stated accounts, and the actual position. ACs that are underprovided for, in terms of financial expertise, and the ability and willingness to dig deep, often compound the problem, since their existence gives rise to expectations that they fall far short of. Time commitment of AC members is also an important ingredient in ensuring audit quality.

Statutory auditors are of course the persons that sign off on the accounts. Even a cursory glance at the auditors’ report would indicate that disclaimers, couched in standard language, significantly reduce the faith that Audit reports and financial statements should create. One immediate requirement is to get the auditing profession to depart from standardised boiler plate statements, and to craft the Audit reports in language that is company specific, and indicative of a higher degree of ownership by the auditors.

RBI has mandated joint audit, presumably to ensure that the deficiencies in audit, attributable to a single auditor, can be suitably addressed. Joint audit has existed in India for many years, especially in the case of public sector banks (PSBs), which have as many as 5-6 joint auditors. The financial statements of PSBs, especially when there are clean reports, give the lie to the contention that joint audit is the magic wand to ensure audit quality.

Independence and professionalism of Statutory auditors has been called into question in recent pronouncements by the NFRA in a couple of cases. For many years, it has been recognised that where non-audit fees constitutes a significant portion of the income of the audit firm from a particular entity, the quality of Statutory Audit should be presumed to have suffered.

While managements and auditors have publicly expressed their intention to reduce the non-audit work done by Statutory auditors, much more needs to be achieved in this direction. There is also considerable obfuscation in regard to this matter since different companies, in their Annual Reports, indicate audit fees and non-audit fees in a manner which does not shed enough light on the payment made for non-audit work. Grouping of some items, which are permissible, and some which should be out of the realm of Statutory auditors, in one common entry, leaves the shareholders and the stakeholders none the wiser as to how the inherent conflict is being addressed.

The fee factor

There is also a tendency on the part of managements and Boards to be conservative when it comes to audit fees. It should be recognised that absent appropriate compensation, the quality of audit is likely to suffer. This is not an area for adopting avoidable economy measures.

Audit fees, commensurate with the scope and quality of audit, should be seen as an investment, and not as expenditure.

Regulators also need to ask themselves what more they can, and should, do to improve the quality of audit. Distrust of the audit profession, arising out of some cases of unacceptable audit quality, often leads to undermining of the credibility of the audit process, for which there is, as of now, no worthwhile substitute. There is a pressing need for Regulators to enter into a continuing and constructive dialogue with representatives of the auditing profession, so that areas for improvement can be identified, and solutions put in place.

If Regulators distrust auditors, and auditors allege regulatory overreach, it would amount to scoring a self-goal, since both of them are, and should be, on the same side, when it comes to protecting the interest of investors, by ensuring that the accounts present a fair and true picture.

Boards should also share a portion of the blame. Leaving all audit and accounts matters to the AC, and spending hardly any time on the accounts when they are brought to the Board, is an act of irresponsibility. If at Board meetings, no questions are asked, and no answers are required to be provided, the AC’s work, insufficient as it might be, will often pass muster.

The good news is that all concerned recognise that there is a problem that needs to be fixed as of yesterday. It will no longer suffice if some of those who have to play a part, stand by and watch the auditing profession being hauled over the coals. A collaborative effort, involving all stakeholders of the process, starting from preparers, and ending with the Board and the Regulator, is a matter that cannot wait any longer.

Clear roles have to be identified, and the responsibilities attached thereto, must be discharged. The alternative is to confront the reality that everyone’s problem is no one’s problem. Shareholders must speak up at AGMs. In the ultimate analysis, if they do not demand quality, it will remain a distant hope, rather than an immediate expectation.


The writer is Chairperson, Excellence Enablers and Former Chairman, SEBI, UTI and IDBI

Published on June 21, 2021

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