How and Why an Independent Audit Matters

Disclaimer: I am not a CA, or involved in this profession. This article is purely for educational purposes, with information collated from multiple news reports, journals and interviews with my CA friends. It is as reported on 1st March, 2020. 

Estimated reading time: 12 minutes

ABSTRACT

On the 6th of February, 2020, the Ministry of Corporate Affairs (MCA), under the Government of India, came out with a consultation paper asking for suggestions to examine the current state of affairs and proposing amendments to enhance the independency and accountability of auditor firms across the country. Exactly a week later, top audit firm PwC announced that it would no longer provide non-audit services to its clients in India. (Non-audit services such as tax advisory and consulting are more lucrative). Following suit, another Big 4 accounting giant, Deloitte, made the same announcement four days later.

What happened? Why such a move now?

As it always happens, we do not try to fix something until it all goes horribly wrong. The recent IL&FS crisis made everyone wonder how two prominent audit firms in the country (Deloitte and a KPMG-affiliate) could incur such a monumental lapse in their judgement and fail to recognize the impending crisis. Although subsequent bans and indictment on the firms followed the event, it is prudent that the regulators look into the big picture and try to address the root cause, so that further collapses do not occur, especially ones which threaten to destabilise the entire financial spectrum such as the IL&FS case.

In this article, I try to elucidate the current oligopoly in the Indian market, with relevant inferences from around the world, with regards to auditing, it’s regulation and offer potential solutions to increase auditor independency.

SEPARATE AUDIT AND NON-AUDIT SERVICES

In light of the two Big 4 firms making such an announcement, let us first try to understand the difference between an audit and a non-audit service. Suppose you are weak in mathematics. You enroll for private tuitions to bring yourself up to speed with the rest of the class. However, your maths teacher at class is the same as your private tutor. Will he be able to assess you fairly and honestly? Isn’t there a tiny possibility of a bias creeping in, if not more? That’s exactly what was happening in the audit scene in India.

Audit firms who were preparing the financial statements for a company were later asked to audit the same, thus seriously infringing on the independency of the firm. These firms also wanted to retain their clients post their auditing assignment, so that they could offer other services like management consulting. What if the firm overlooks a detail in the audit to influence the company to hiring them? 

Figure 1.1 lists down the services that an auditor shall not provide to the company or holding company under Sec 144 of the Companies Act, 2013. The afore-mentioned consultation paper has asked for suggestions regarding what additional services should be brought under this Section. My suggestion? Any work other than certifying financial statements should fall under non-audit services.

A recent article by Economic Times estimated that such curbs on non-audit work will hardly have any impact on the Big 4 firms. These firms generally combine tax advisory with audit, but the former hardly makes for 10-20% of the total work. Small homegrown firms, though, may be hit harder since they make more from the tax work. Additionally, the ICAI (Institute of Chartered Accountants of India) bars audit companies to earn more from their non-audit work than their primary auditing work. The situation is not very different outside India. Throughout the globe, regulators are worried about this. This is why the US came out with the Sarbanes Oxley Act, 2002 that laid down atleast eight services that could not be offered to audit clients. In the year 2016, EU came out with a similar provision as well. Fig 1.2 reveals the revenue of the Big 4 firms worldwide, 2019, by function. As you can clearly see, revenue from auditing makes up less than 40% for all four firms. 

Now you understand why they're desperate for additional non-audit work?

BREAKING THE OLIGOPOLY

IRCTC is a monopoly. With Vodafone-Idea at the brink of a shutdown, the telecom sector is aiming for a duopoly. When I say “audit”, if all you can think of is Deloitte, PwC, EY and KPMG, behold, you have an oligopoly! 

So what’s the fuss all about?

For starters, the Big 4 constitute 70 percent of the market share in India. In UK, they have captured 97 percent of the market. I have attached an infographic (Fig 2.1) so that you can visualize the concentration in the US market (99% concentration). What it essentially means is that if you want to build an audit firm from scratch, it gets increasingly difficult for you to penetrate this market and get clients. Remember barriers to entry in the Porter’s 5 forces model? They have nowhere to go and eventually get scooped up by one of the Big 4 – and we’re back to square one! PR Ramesh, former Deloitte India Chairman, believes that India needs more large audit firms. However, it cannot be achieved by breaking down the Big 4. To be fair, the Companies Act of 2013 have incorporated measures to address this – such as mandatory rotation of audit firms and the option of joint audits – but these measures have largely fallen short. When the time of rotation nears, the auditee generally chooses another Big 4 firm. Even in the cases of Joint Audit for complex cases, companies prefer two Big 4 companies in their roster. Give the small guys a break!

What is the solution to this?

Firstly, we need to create a healthy ecosystem for small homegrown audit firms to survive, and then thrive. This is improbable unless regulation mandates it. For example, Joint Audits can be made compulsory for large listed firms. In this structure, firms can choose to employ one firm from the Big 4 and mandatorily hire a small firm as the second auditor. 

Secondly, a separate panel can overlook the consolidation of smaller firms so that they can become more equipped to handle the audit for large firms. Case in point: recently, Grant Thornton has emerged as a new challenger to the Big 4, potentially toppling PwC, as the latter is mired in bans and indictment. Fig 2.2 depicts the ranking of auditor group by number of audits as on December 9th, 2019. (In case you're confused, that Walker Chandiok & Co LLP is the affiliate of Grant Thornton in India)

Finally, the same panel can oversee the appointment of auditors for various listed and unlisted firms across the country. A separate panel will ensure transparency and efficient monitoring. Who should set up this panel? I believe a responsible, well-feared organization body in India such as the CAG (Comptroller & Auditor General) of India or the SEBI (Securities & Exchange Board of India) should initiate this. 

MASTER REGULATOR

Indian banks are governed by the RBI. Exchanges and mutual fund houses are governed by SEBI. These regulators are revered because of the autonomy that they have been provided, free of any and all encumbrance in their judgement by the Government of India.

But who governs the auditing profession in India?

ICAI. (Institute of Chartered Accountants of India)

1st July 1949. That was when this institution was founded. It falls under the administrative control of the MCA of the central government. To summarize it’s role, here is a quote by Prime Minister Narendra Modi from 2017,

"CA is an arrangement in which the human resource development is done only by you. The curriculum is made by you only; you conduct the exam; rules and regulations are also made by you, and your institute only punishes the culprits."

The Prime Minister went on to reiterate how ICAI has failed to persecute Chartered Accountants for an umpteenth number of cases against them. This, along with multiple other sentiments, led to the birth of what we now know as the NFRA or the National Financial Reporting Authority, in 2018.

The NFRA is parallel to the Public Company Accounting Oversight Board (PCAOB) in the US set up by the Sarbanes Oxley Act as mentioned previously. While it has been set up to replace some of the powers of the ICAI, this body can oversee the panel responsible for the appointment and rotation of auditors across the country. Officially, the broad areas for the body are “recommending accounting and auditing policies and standards in the country, undertaking investigations, and imposing sanctions against defaulting auditors and audit firms in the form of monetary penalties and debarment from practice for up to 10 years.”

This March, 2020, NFRA is going to step on it’s second birthday. So how has it fared?

The body is headed by former IAS officer Rangachari Sridharan. Although this was done keeping independence in mind, The ICAI has not took too kindly to this, with some members being outraged that it is not someone from the CA profession. However, personally, I feel that the more pressing issue is that, out of a panel of 15 members, seats of two full-time members are still vacant. More worryingly, no new accounting or auditing standards have been issued in the past year for recommendation. 

Is it doing anything correct? Yes. As recent as December last year, the NFRA has sought details from top audit firms in the country, of their clients, the audit process followed to evaluate them, the fee structure, details of non-audit work, if any, and also details of the qualifications issued to the companies for their financial accounts. Expectedly, some firms have cried out that this is too much information to process and gather, but the focus is to create stricter regulations. Currently, the audit firms issue a qualification after evaluating the financial statements. Fig 3.1 enlists them. This opinion, some feel, is an escape for the firms to not take a stand on the issue. NFRA may look into this as well.

Update: As on 25th February 2020, the GoI, in consultation with the NFRA, has made changes to the Companies Auditor Report Order (CARO), which stipulates that more than double disclosures have to be now made by the auditor. These include noting the ever-greening of loans (rolling over loans once they mature with a new loan), consideration of whistle-blower complaints, opinion on financial ratios, title deeds of assets and more. This really irked the audit companies, and as a response, they have said that they might hike their fee from the next financial year. Reasonable demand? I think so.

“No man can serve two masters: for either he. will hate the one, and love the other; or else. he will hold to the one, and despise the other, Ye cannot serve God and mammon.” – Matthew 6:24. 

We need to sort the issue of multiple masters. Auditors are bombarded with six regulators as things stand now. SEBI scrutinizes auditors of listed companies; the RBI audits banks and non-banking financial companies (NBFC); MCA tracks nearly every company under Companies Act 2013; criminal proceedings are conducted by the Serious Fraud and Investigations Office (SFIO), disciplinary proceedings by ICAI and finally penal action by NFRA for audit lapses.

We need to bring all of them under one umbrella and enforce them stringently. Let’s hope NFRA will suffice.

TOO LATE, TOO MUCH?

I had begun this article with the consultation paper by MCA. The organization will accept suggestions and comments till the 15th of March, post which, it will hopefully come out with a decision. However, the paper has been widely criticized for it’s attempt at regulatory overreach. To quote an IIM-Bangalore finance & accounting professor, "Bad English is a shortcoming, but the intellectual quality of the work is underwhelming." Vishesh Chandiok, CEO, Grant Thornton, feels otherwise,

“I would not call regulator going overboard just by bringing out a consultation paper. It is a good move. I would consider it as going overboard if we end up with many changes in regulation.”

Which brings us to the question: Will all of this backfire?

While I maintain that there is should be a blanket ban on all non-audit work to remove ambiguity, the regulator and the government should make sure that small firms do not cripple under this ban, as a major chunk of their revenue stems from the consultancy fees they generate. Furthermore, in an attempt to prop up these homegrown firms, they should ensure not to drop the audit quality of the entire industry, as all firms may not be equipped to deal with complex audit work. Also, not carrying the brand value of the Big 4, these firms may be forced to drop their prices, but incur high costs of development and resources, thus striving for long to survive in the industry.

We need to debunk the myths surrounding the issue as well. This is not a “swadeshi” dilemma. Although the Big 4 names are all multinational, they are essentially Indian firms using the affiliate network. Instead, let us treat auditing as a precaution rather than the post-mortem exercise it currently is. 

ICAI, frankly, needs to move on. For years, it resisted the formation of NFRA, in the fear of losing power. Even today, it does not hesitate to voice out against any lapses by the latter. This needs to stop, for the betterment of the entire profession. Instead, it can help the NFRA in its job. We have to understand that a lot of systems and checks and balances are already in place. But they are useless if not enforced. For instance, the 2017 Kotak Committee Report on Corporate Governance, talked about disclosure of reasons of the resignation of auditors; still, many auditors randomly resigned post the PNB scam, fearing regulation. 

Yesterday, think tank CEPR (Centre for Economic Policy Research) said that audit committees of boards of companies need to play a more active role in overseeing the entire financial reporting process. We can't just always blame the auditors because it's easy, right?

In the end, keeping all of this in mind, let us hope we make the job easier for Chartered Accountants, rather than the other way around.