Can a broken songbird sing?

It is a scary time for the big four auditors in India. Their worry is not so much the business model of providing audit and a myriad of non-audit services; that, if regulators demand, they will reluctantly tweak just so. It is the audit quality and the numbers they have recently printed, that shareholders, lenders and regulators are now questioning. The Securities and Exchange Board of India (Sebi) banned PwC in 2018 from auditing listed companies for two years for its involvement in Satyam Computers Services Limited. Last month, the Reserve Bank of India barred SR Batliboi & Company LLP, an affiliate of EY, from carrying out statutory audit assignments of commercial banks for one year. The Serious Fraud Investigation Office has charged Deloitte Haskins & Sells LLP and BSR and Associates LLP (part of the KMPG network), for their failure in not disclosing the true financial health of IL&FS Financial Services Limited and the Ministry of Corporate Affairs (MCA) looks at banning them from undertaking audits for a period of five years.

 

How have things come to such a pass? One, the change in audit rules. From principles of prudence and conservatism, which enabled auditors to certify that the numbers are “true and fair”, there is a shift to “fair value” which despite its theoretical underpinnings, has led to Sharon Bowles, a former chair of European Parliament  economic and monetary affairs committee, to describe it as the “un-anchoring of auditing from verifiable facts”. My own experience while handling an IPO of a technology company in the late 1990s was the trepidation of its CFO when asked to prepare US GAAP accounts, giving way to high-fives, when he realised that management assumptions could be far more generous than what his local auditors allowed. Indian audit rules are far more aligned with global rules today, than any time before.

 

And rather than being “useful to users” fair value accounting has at often times left investors at the mercy of the auditors — who have just ticked the box, rather than exercise their judgement: in Charlie Munger’s words “violated the most elemental principles of common sense”. Auditors defend themselves saying that it is difficult to over-ride management when it comes to exercising judgement on business issues; recent events suggest they need to push-back, as PwC has recently done. 

 

Some argue that audit failure to provide robust results is a consequence of their cosying up to firms they audit, in the hope of non-audit related business. Today the big four companies audit 60 per cent of the NIFTY 500 firms, thankfully not as dominant as in the UK (97 per cent of the FTSE350) or US (99 per cent of the S&P500). Deloitte’s global revenues in 2018 were US$43.2billion, followed by PwC (US$41.3 billion.), EY (US$34.8) and KPMG (US$29.9billion). Between themselves they employ 1,005,753 people. Just to put this in context, Morgan Stanley’s global revenues for 2018 were at US$37.9 billion and those of Goldman Sachs, US$36.6 billion. The UK’s Competition and Market Authority (CMA), in its recent review of the audit industry, found that each of the Big Four generates at least three quarters of its revenue from non-audit services. One consequence is that large are getting larger. What then needs to be done? Should they be splintered into smaller ‘all service’ firms, should they be vertically split into audit only  and non-audited firms or should there be a hefty fine for each transgression and they be allowed to continue, if the market believes they are now too important to do without? If the market believes moving forward without them is too disruptive. A practical but short-term solution.

 

As the big four audit firms brace themselves for a shakedown, it is not clear who the winners will be. The domestic firms, for the most, have merged with the big four — their skills, but far more their roster of clients, was far too attractive to the majors to leave untouched. Can the handful of remaining domestic firms benefit from this? It is not obvious if they now “have-it” to compete; partly this is because the companies are much larger, more global and more complex, which puts the smaller firms are a disadvantage vi-a-vis the big boys.  And in part, because investors push firms to embrace the Big Four. The current crisis provides them with an opportunity, and it will be a shame if they do not take advantage that this environment provides. No one will argue that we don’t need more choice. Indeed, the more daring amongst us will argue voting out the Big Four (assuming the regulators don’t ban them) and bring in the smaller firms arguing that the big four have not provided the assurance their brands promised. HDFC Bank recently appointed MSKA & Associates, a firm outside of the big four. Its own credibility will compensate for that of its auditors. This could be the starting point of rejuvenating the industry, with the better governed firms moving beyond the big four.

 

In India, a Committee of Experts in its report to the Ministry of Corporate Affairs focused on the ownership structure, found it in compliance with Indian law, and believed that the National Financial Reporting Authority will solve the various intractable issues that face the industry today. In sharp contrast, the CMA in its report has suggested breaking-up the big four to increase choice and introducing joint audits, which will enable smaller firms to upskill themselves — the two issues which we In India grapple with  today. Agreed that just having more firms will not solve by itself solve the quality problem. So, to this let me add a third, tight oversight over audits and auditors.

 

Change will take time and most needs wider debate. Meanwhile I advocate institutional investors and even audit committees, get involved in the policy debates around audit standards. Albeit an arcane subject, the ramifications are too far reaching and too long term, to ignore. Quicker still, investors should be more questioning of audit reports and auditors should open-up to talking to shareholder who vote their appointment, rather than cite client confidentiality.

 

The chartered accountants, possibly envious of doctors with a sticker of either a red-plus sign or the Rod of Asclepius on their windshield, decided to march in step with them, and put a ‘CA’ sticker on their windshield. As an aside, my colleague Hetal Dalal often asks, what is the relative probability of someone stopping a doctor on the roadside for a medical emergency versus flagging down a bean counter to give a tax opinion. Having embraced and made their own the sticker, auditors should go the full distance by paraphrasing and embracing a line about physicians from the bible. Let me help with it. Auditor, heal thyself.  

 


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