To improve audit quality, increasing oversight is a far better approach than trying to increase competition by imposing regulatory limits on audit engagements.
In a market like India, where corporate governance concerns are top of mind for investors, the role of auditors in providing assurance to investors is critical.
However, audit firms have been facing increasing scrutiny in recent years, be it globally for their alleged deficiencies in audits of Wirecard, Carillion, or General Electric, or in India for their role in PMC Bank, Punjab National Bank, or the finance company Infrastructure Leasing & Financial Services (IL&FS).
Earlier this year, the Indian Ministry of Corporate Affairs (MCA) floated a consultation paper on audit independence and accountability, covering far-reaching reforms in the audit market, from reviewing the concentration of the Big Four in the market, auditor appointments and joint audits. While these proposals rightly caught the attention of stakeholders and the media, the paper also contained other proposals, which if implemented will make material improvements in audit quality.
Proposals that generated the most attention
Let’s consider the most discussed issue in the paper, which is reducing the concentration of the Big Four firms. The paper discusses limits on several dimensions, like the number of audits per firm or auditors, or the number of partners per audit firm, and in general how to reduce the workload of the Big Four firms.
The Big Four firms haven’t acquitted themselves well in several instances, and in the case of Wirecard and the erstwhile Indian software major Satyam, even implicated for their failure to properly account for cash balances. The desire to look beyond them is understandable.
However, for a market to be perfectly competitive, not only does it need numerous buyers and sellers, but it also needs them to be well informed. In the current audit market, buyers of audit services – ultimately investors – do not have the information necessary to judge audit quality, leaving behind a market for lemons. In this scenario, increasing competition without a commensurate focus on audit quality may result in increased price competition and a possible reduction in audit quality.
The paper proposes auditor appointments could be made from a panel maintained by an independent agency and argues that the current scenario where management decides the choice and remuneration of auditors leads to conflicts of interest. However, Indian listing regulations already place the onus on recommending appointment and remuneration on the audit committee comprising of independent directors (not management), and subject to approval by shareholders. This is how it should be. To reduce the conflicts of interest further, audit committees should also have authority over their budgets and over statutory auditors. It is through these protections that investors will come to trust the financial reports issued by companies. While regulators could provide additional scrutiny of audit committees, the proposal to replace their role in auditor appointments would be counterproductive and take away scarce regulatory bandwidth without improving audit quality.
The paper also discusses mandatory joint audits and the so-called “four-eyes” principle to reinforce audit quality. Joint audits do not improve audit quality; they create competition for management and audit committee approval to the detriment of audit quality. They also reduce accountability to investors. Such audits require careful coordination, cooperation, and division of responsibility between two firms and then communicating them to investors. Barring such safeguards, merely getting an opinion jointly signed by two firms would not be an improvement.
Least discussed but most promising ideas
While these issues have generated the most attention, there are other modest proposals which have the potential to improve audit quality in a meaningful way.
The proposal to enable the auditor of holding companies to comment on the working papers of subsidiary companies is a useful measure in group companies which employ different audit firms for parent and subsidiaries; listing regulations already require auditors to undertake a limited review of entities which are consolidated with the listed entity. The proposal for concurrent audits of large transactions is also useful and would serve as an early warning system.
But the biggest improvement in audit quality would come from the proposal for regulatory inspection of audit engagements as a means of supervision and enforcement. Regulators across the world, like the Public Company Accounting Oversight Board in the USA, the Canadian Public Accountability Board, and the Financial Reporting Council in the UK employ various selection methods based on the audit firm size and risk profile of the industry and issuers; within the selected engagements, the regulators focus their attention on the more complex, challenging, or subjective areas. The resulting public inspection reports provide investors with useful information about the extent and areas of deficiencies and incentivises audit firms to improve their processes over time.
While the impulse for big changes and signalling intent in the face of diminishing trust is a natural reaction, regulators could improve audit quality in a meaningful way by focusing on tighter enforcement of existing rules and providing oversight of audit committees and audit firms.
Sivananth Ramachandran (Siva), CFA is the Director of Capital Markets Policy, India at the CFA Institute. He is also a CRUF India participant. He is responsible for advocating policy positions on issues that impact Indian capital markets, including corporate governance, ESG, and financial reporting. Siva was part of a SEBI working group that reviewed the related party transaction regulations.
Disclaimer: The views expressed in the blog are those of the author(s) and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.