Audit reforms should go far beyond knee-jerk reactions

Auditors have often been in a spot for their failure to detect financial frauds in high-profile corporate collapses. The regulatory architecture for audits has been subjected to radical reforms after every major corporate fraud since the requirement of an audit was first mandated in 1844 under the Joint Stock Companies Act. Ironically, despite this, audit processes and the auditing profession continue to face the challenge of ensuring quality and instilling confidence in stakeholders.

The collapse of Enron in 2001 not only led to the demise of one of the then ‘big five’ accounting firms, Arthur Andersen, but also a structural shift in how the auditing profession is regulated—from self-regulation to external regulation, now with a special focus on measures to avoid potential conflicts of interest in various kinds of audits carried out the world over. In India, The Institute of Chartered Accountants of India (ICAI), the accounting regulator set up by an Act of Parliament, was put to greater state intervention. In addition, an independent (audit) Quality Review Board was set up.

The unravelling of the Satyam scandal in 2008 shaped the new audit architecture in India. The Companies Act of 2013, among various other measures to ensure the independence of auditors, provided for the establishment of an independent regulator, namely the National Financial Reporting Authority (NFRA), along the pattern of the Public Company Accounting Oversight Board (PCOAB) in the US. The NFRA, however, stayed in suspended animation for four years till the unearthing of a scam at Punjab National Bank, which led to its operationalization in October 2018.

Meanwhile, the UK government, not content with the efficacy of its present independent regulator, the Financial Reporting Council, is contemplating a new regulator that may report to and be accountable to the country’s parliament. The big four there have also been given a timeline to hive off their non-audit services.

Unfortunately, the reform responses so far have been knee-jerk reactions to the public outcries that followed the collapse of high-profile companies, and have remained peripheral to issues that are fundamental to the conduct of an audit. India’s ministry of corporate affairs has floated a consultation paper on audit regulation, and the UK government is contemplating another dose of audit reforms.

It is evident that in cases of corporate collapse, such as Satyam and DHFL in India or Enron in the US, financial reporting was ingeniously used to cover business failures or hide financial frauds for a number of years. The failure of audit processes to sense and detect these is inexplicable. From an investor perspective, an audit is incomplete, if not meaningless, unless it reports any vulnerability to and signs of fraud. Auditors, however, have often been shy of assuming their responsibility for the detection of wrongdoing.

The mere exercise of extra scepticism while conducting an audit, required as per recent changes in auditing standards, may not suffice. It is high time that either the scope of audits under the Companies Act is expanded to include elements of forensic auditing, or a separate forensic audit is mandated, at least for large listed companies and entities in which public interest is high .

Ensuring the independence of auditors is crucial to soliciting trust in the process and is no less important than strict adherence to the technical standards of auditing. Reform measures in the past have failed to sever the nuptial cord between company managements and their auditors. The Companies Act’s requirement of auditor appointments made through audit committees has acted as just a facade. In reality, it’s usually managements that control appointments. This job, as also determination of the audit fee for large listed and public-interest entities, should instead be done by an independent agency, as is the case with board-level appointments at public sector banks.

Restrictions on non-audit services by specifying which are allowed and placing limits on payments for these as a percentage of the audit fee have not worked either. Till such time that audit fees are insufficient compensation for high-quality audits, audit firms will continue to solicit business from the firms they audit for other services. At times, audit fees do not even cover direct costs. The message, then, is loud and clear: Prohibit the provision of non-audit services by auditors and institute regulatory guidelines for determining audit fees, rather than leaving it to the process of negotiation or tender issuance. Over the years, auditing has become onerous and non-remunerative, driving away talent and shifting its focus from quality to box-ticking. Reforms should ensure professionalism that places quality above revenues.

Small and medium audit firms, which make up the vast majority of this profession, should also get a chance to enhance capacity and show they’re well equipped to do quality audits. The concept of joint audits with larger firms, a focus on minimum infrastructure requirements, the enabling of access to top-notch audit software, and the facilitation of networking for small firms to gain the advantages of size are some issues that regulators have failed to adequately address.

Enforcing auditor discipline is important but not enough to improve audit quality. Regulators themselves should be put to an independent assessment for the efficacy of their reform initiatives—or lack thereof.

Ashok Haldia is former secretary of the Institute of Chartered Accountants of India