Towards Better Corporate Governance – Strengthening Audit Framework

The decision by two of the top audit firms not to take non-audit work for their audit clients, is the culmination of regulatory efforts to improve the standard of corporate governance. However, the immediate trigger is a discussion paper, floated by MCA (Ministry of Corporate Affairs), which proposes a variety of measures to make audit procedures more independent. Here is a look at the issues raised and proposals suggested by the paper.

Audit and other corporate facing services have been going through intense scrutiny subsequent to surfacing of frauds at IL&FS, DHFL, HDIL etc. The failure of auditing agencies in these cases led to the remark by a regulator, “While the audit procedure is not expected to find needle in the haystack, if it not able to detect the ‘elephant in the room’, something is seriously wrong”. The instances of collusion are not new. Corporate India was rocked by the Satyam scandal over a decade ago, where the auditors were found to be hand-in-glove with the promotors.

The discussion paper is quite blunt in its elaboration and begins with a basic fallacy – though auditors are appointed by shareholders to safeguard their interest, the effective power of appointment and dismissal lies with management. This has even greater implication as not only shareholders but other stakeholders such as lenders, regulatory agencies, government and public, in general, also look up to their reports to get a true picture of the company.

The paper touches upon five threats that auditors face and measures to remedy these. These are self-interest threat, self-review threat, advocacy threat, familiarity threat and possibly, the most important, intimidation threat. Self-interest threat arises as the auditor is dependent on the auditee for fees and other non-audit assignments. The auditor doesn’t have much recourse if the management stops such assignment in case the auditor’s review is not to their liking. Self-review refers to a situation where the auditor audits the financial statement of a company which has been prepared by another team from the same firm. It is highly likely that the auditor would accept the statement and not raise objections even if he finds any. The Advocacy threat arises when the audit firm promotes the interest of the client, for its own benefit.

While some firms may maintain sufficient degree of independence on these counts, it is difficult on the last two. A report on global financial crisis alluded to partner of an audit firm playing golf with the CEO of the auditee, a case of ‘familiarity threat’. A study of corporate frauds would reveal how years of working together brings-in a certain sense of complacency and reluctance on the part of auditors to raise red flags. The last, ‘intimidation threat’, has a much serious connotation as it is not restricted to dismissal or discontinuation of other assignments. There have been instances when clients with clout in corridors of power have used threat of litigation, even jail to suppress irregularities.

The paper suggests several measures as remedies. The first is prohibiting non-audit services entirely (against a negative list currently existing), mandating a minimum fee so that there is no cut-throat competition to win an audit and subsequent compromise in quality of audit etc. Another suggestion worth mentioning is appointment of auditors by external agencies like CAG. However, some of the suggestions appear unusual and unimplementable such as prohibition/ restriction of personal relationship.

Other than these threats, the discussion paper also makes note of issues affecting the quality of audit, one of which is dominance of ‘big four’ firms. While the paper notes that 70% of audit work of listed firms in India is done directly or indirectly by the big four, it doesn’t have any firm proposal to reduce this. Some of the ways to do this could be mandating joint audit with a smaller firm for say, at least half of the audit assignments, building a corpus to provide financial support to new firms for initial years etc.

Two other important measures suggested by the paper is – initiation of concurrent audit and submission of quarterly returns of unlisted subsidiaries if the parent company is listed. Concurrent audit refers to involvement of lenders to check proper utilization of funds lent. While MCA looks set to mandate this, the discussion revolves around the threshold to make it compulsory and scope of such audit. The other issue is also far reaching as unlisted firm offers an easy way and have often been used to hide irregularities for promoters with ulterior motive.

The discussion paper is far reaching, although harsh in some ways, and provides a way forward to make auditors, a watchdog again. Audit firms also appear to be waking up to the new reality as evident by series of resignations citing non-cooperation, non-sharing of information etc. Yet, controlling the ways of an ingenious and sinister mind is an everlasting challenge and if India Inc is hit by audit failures again, a decade from now, it won’t really be surprising. It would be pertinent to mention what a leading, well respected industrialist once wrote, “I would rather hire a person with high integrity and low intellect than a person with high intellect and low integrity. The damage, the later can cause, is much higher”.

(Image courtesy of Stuart Miles at freedigitalphotos.net)

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