Are regulators expecting too much from audit?

On February 6, the Ministry of Corporate Affairs (MCA) issued a consultation paper on the independence and accountability of auditors. The last date for submission of comments/observations is February 28. The accounting code of ethics requires audit firms to identify threats to independence for each audit assignment and decide adequate and effective safeguards against those. The consultation paper has suggested building protection against those threats in the regulations. It also flags the important issue of the concentration of economic power with Big 4 audit firms, affiliates of which audit 70 per cent of the 1,800 companies listed on the National Stock Exchange (NSE). It has also flagged some other important issues. 

The corporate law gives shareholders two important rights — to appoint the directors and, to appoint the auditor. The board is expected to act as trustee for shareholders’ fund invested in the company.  The auditor protects shareholders’ interest by providing reasonable assurance that shareholders’ fund is not expropriated by the management or wasted because of fraud, etc, although, audit is not investigation and fraud detection is not the primary audit objective. For all practical purposes, those shareholders’ rights are non-existent. The corporate democracy follows majority rule (one share, one vote). Therefore, in companies where there is concentration of ownership, management’s nominees are appointed to the board and as auditor. The situation is no different even in companies where there is no concentration of ownership. The incumbent management plays an important role, sometimes tacitly, in appointing directors and the auditor. Therefore, audit independence is always under threat. The issue is being discussed for umpteen numbers of years. 

For the first time, the government included a number of provisions in the Companies Act, 2013, to improve audit quality. For example, rotation of auditors and restrictions on providing other services were introduced. Audit reforms in India are aligned with reforms introduced in many other countries. The profession itself is concerned about increasing reputation risk.  To protect and enhance credibility, the profession is issuing new auditing standards. For example, aligned with the global practices, auditors in India have started reporting key audit matters (KAM) — those which in the auditor’s professional judgement were of most significance in the audit. Disclosure of KAM is expected to enhance the understandability of the audit report.

The year 2019 was bad for the auditing profession in India.  During that year, five auditors, including some partners of a Big 4 firm, were arrested. The National Financial Reporting Authority (NFRA) issued detailed Audit Quality Review (AQR) Report for the year 2017-18, explaining how the auditor (one of the Big 4 firms) of IL&FS Financial Services failed to comply with auditing standards, and thus, compromised with independence and audit quality. The NFRA has lent a fresh perspective to auditor’s independence and "professional skepticism". 

The auditing profession has started showing stress symptoms. During April-September 2019, 35 auditors resigned before completing the audit. The figure was three, five, and 24 during the same period of 2016-17, 2017-18 and 2018-19, respectively. The spurt of resignations prompted the Securities and Exchange Board of India (Sebi) to bring a new regulation to address the issue.  

The auditor’s approach has changed over past decades. Earlier, when in doubt, auditors insisted the management add a clarificatory note to accounts. Subsequently, when in doubt, auditors added a section in the audit report on ‘emphasis of matter’ to draw attention to matters that are fundamental to users’ understanding of the financial statements. In the decade that started on January 2020, Sebi’s new regulation will push auditors to qualify the audit report or issue disclaimer, when in doubt. Disclaimer is a statement that the auditor was unable to form opinion because of non-cooperation by the client or for some other reason. To be on the right side of the line and to protect reputation and the credibility of the firm and the profession, auditors are likely to take very conservative view in formulating professional judgements. This will worsen the tension between the management and the auditor. Only time will tell whether regulatory actions will benefit or hurt shareholders. 

Do shareholders share the same concerns as those of regulators? Are they ready to bear the incremental cost of additional audit procedures? Should we redefine the auditor’s role? Are we driving out talent from the auditing profession? Regulators and institutional shareholders should search answers to those questions.

The writer is director, Institute of Management Technology Ghaziabad
 e-mail id: asish.bhattacharyya @gmail.com




Business Standard is now on Telegram.
For insightful reports and views on business, markets, politics and other issues, subscribe to our official Telegram channel