Opinion | The case for a new framework to ensure auditor independence

Auditors in particular and the auditing profession in general have often been portrayed as the main culprits in corporate frauds and failures and alleged to have been in active connivance with the management of the concerned companies. To be fair to such critics, this is natural because of the general understanding of the scope of an audit and an auditor’s proximity to the cause of the fraud or failure, which is usually financial.

Recent high-profile corporate collapses/frauds of the likes of Infrastructure Leasing and Financial Services (IL&FS) in India and of Carillion and BHS in the UK have shaken the Big Four auditors. Regulators are debating measures such as banning these beleaguered firms and amputating the non-audit services rendered by them and are also considering various structural changes in the regulatory framework. The audit regulator in the UK, the Financial Reporting Council, which is akin to the recently set up National Financial Reporting Authority, or NAFRA, in India, is likely to be replaced by an authority accountable directly to the UK Parliament. The role of The Institute of Chartered Accountants of India (ICAI), the regulator for CAs in India, was made peripheral by the operationalization of NAFRA after the Punjab National Bank fraud.

Unfortunately, these and other measures taken in the past have failed to stop accounting and auditing failures as governments and regulators worldwide have shied away from addressing the underlying malaise that compromises the independence of auditors.

An audit is carried out in the public interest. Therefore, the appointment of auditors and determination of their remuneration has to be totally and effectively made independent of the audited company’s management. Any measure short of this, like the one introduced through the Companies Act, 2013, routing the appointment of an auditor through an audit committee, or restrictions on non-audit services provided by the auditor, or requiring auditors to separate their audit and non-audit services through a so-called “Chinese wall”, would be inadequate in ensuring quality audits. It is universally recognized that high-quality technical standards, tools and techniques are effective only if auditors remain independent and objective in their functioning and are able to challenge management decisions.

The present dispensation for the appointment of auditors through an audit committee is under criticism the world over, despite regulatory and legal stipulations on maintaining the independence of such an audit committee. In reality, the “cultural fit” of auditors, the chemistry they share with the management, tends to get precedence in appointment. This way, the ability of auditors to remain objective and professionally sceptical is severely compromised. Public expectations from an audit process being so high, experimentation with and around the existing framework may not be enough to restore trust in audits. Making audit committees directly accountable to regulators, as being explored in the UK, or any attempt to define parameters for hiring an auditor, would not yield the desired results. It is time for radical measures. The markets regulator, the Securities and Exchange Board of India (Sebi), should be made responsible for the selection of auditors of public-interest entities. This could be done by itself or by an independent agency set up for the purpose.

Till a few years ago, the auditors of public sector banks were appointed by the Reserve Bank of India out of a panel prepared by the ICAI, according to prescribed criteria. It soon succumbed to the demands of bank managements for autonomy in the matter. The new mechanism is widely criticized, not least for malpractices, and continues despite the ICAI pleading against it time and again. The UK is also considering the appointment of auditors for FTSE 350 companies by the regulator.

For public interest entities, Sebi or any independent agency may prepare a panel of auditors based on pre-determined criteria and designate them for appointment by the company, following the process required under the Companies Act. This is a novel concept but is possible. Sebi is already empanelling and appointing forensic auditors in suspect entities.

Audit firms clamour for non-audit services to cross-subsidize their audit services, arguing that if they are not able to audit, quality would be the first casualty. The structural or operational separation of audit and non-audit services sounds sufficiently radical. Yet, it may not address issues of independence or conflict of interest. Rather, the solution lies in making audit fees remunerative—indeed, commensurate with the true cost of a quality audit.

What people expect of auditors in terms of scope and skills are on the rise. The audit fees, however, are not. In recent years, fees have actually shrunk under competitive pressure. Audit committees in general have failed to ensure that audit compensation is sufficient to cover the extra work sometimes needed when an auditor discovers things that need close inspection—for example, suspect transactions. It is common knowledge that audit fees for bank branches in some cases do not even cover the cost of junior audit staff deployed. Unfortunately, in the ongoing debate, audit economics is not being talked about.

Audit fees should be based on the complexity involved and work to be done. High quality necessarily leads to an increase in cost, but that is imperative for an audit that can be trusted. Sebi should also warrant disclosures of audit fees, skill sets deployed and hours spent on audits. This would allow us to assess the fees paid in comparison with inflation and increases in the pay packages of senior management, and also with other companies.

Regulators should create an ecosystem where auditors do not have incentives to compromise the integrity and standards they are expected to uphold. Audits serve the public interest and their quality should concern us all.

Ashok Haldia is former secretary, Institute of Chartered Accountants of India (ICAI).