Policy | If the ‘market knows’, why doesn’t the auditor? Part 2

Representative Image

In Part 1, we discussed the questions being raised by market participants of auditors. In Part 2, we discuss the issues of regulatory oversight, conflict of interest, capabilities beyond the big four, auditor resignations, and what the future holds for the industry.

 Regulatory oversight

Can the answer here too lie in enforcement? The dominant regulator for the audit industry, until recently, was the Institute of Chartered Accountants (ICAI), which did little to promote better industry standards. The ICAI’s Quality Review Board (QRB), which is responsible for the review of audit quality, has reviewed just 580 audit engagements over six years between 2012-2018, of which it found only 39 per cent to be of generally accepted standards.

Despite the abysmally low volume of reviews, the results are reflective of what the market experiences. Less than half the audits are of acceptable quality. Even so, there has been no sense of urgency in the ICAI’s effort to raise audit standards. The creation of the National Financial Regulatory Authority (NFRA) is possibly the next hope for imposing accountability within the audit industry.

It is this market frustration over the weak regulatory oversight that has led different bodies usurping oversight on the audit industry. The accountability of auditors was first enshrined in the Companies Act 2013, which brought penalty provisions for auditors. The Reserve Bank of India (RBI) banned an audit firm from auditing banks, which is well within RBI’s purview, since all bank auditors need to be approved by the RBI. SEBI decided to use its discretionary powers over market fiduciaries to ban PriceWaterhouse in the Satyam case. In expecting SEBI to establish criminal culpability of auditors before exercising its oversight powers, SAT has done a disservice to investors and misread market expectations. The market has been itching for SEBI to take a stand on auditors.

The market regulator unfortunately both dithered and overreached in holding the auditor accountable. The decision came a decade after the event, during which time the people running the audit firm, and the practices that the firm followed had changed materially. While it had certainly done its homework on the responsibilities of the auditors, it should have accounted for a more graded punishment mechanism — simply banning the entire firm, at this late stage, was perhaps a stretch.

Issues of conflict

This is also the best time for the industry to question if there is a conflict of interest for partners: at times incentives are linked to revenues. While at a leadership level it may be difficult to separate revenue targets as performance criteria, perhaps at the operating level separation of business targets and analytical quality needs to be administered. Rating agencies and even proxy firms have separated business and analytical targets — the audit industry needs to quickly take heed.

Capability beyond the big four

With all the ‘Big Four’ audit firms are grappling with regulatory action, each for a different reason, the other looming question for the markets is whether domestic firms (not affiliated to international networks) have the capacity and the capability of conducting audits of large listed companies. This question is central to the debate, as accounting moves towards becoming more judgement-based, for which wide-spread institutional experience and memory are needed. Although both domestic and foreign audit firms reiterate that capacity and capability of audit firms are fit for purpose, the lingering doubt continues in the minds of audit committees and investors.

Auditor resignations

Auditor resignation has worried investors. More so if auditors resign during the year, before signing off on the year’s financial statements. In several instances, following the appointment of a new audit firms, adverse remarks made by the outgoing auditor (in quarterly statements) have quietly disappeared and a clean audit report has been issued by the newly-appointed auditor. Auditors argue that resignations are not that uncommon — it wasn’t noticed earlier because of the annual appointment of statutory auditors. With five-year terms, the resignations appear more pronounced — earlier they just did not get themselves re-appointed.

Even so, the concern over auditor resignation was important enough for SEBI to publish a circular on Resignation of Statutory Auditors from listed companies and their material subsidiaries. The circular does not allow auditors to simply walk away — it encourages audit firms to either complete the audit or publish a disclaimed opinion. While this will likely increase the discord between warring managements and audit firms, it may well be in the interest of all stakeholders.

Looking ahead

The creation of an ecosystem that compels better audit quality is a possible solution. There needs to be an industry-level focus on strengthening audit quality — one that does not ignore what the market already knows. Leaving it alone to regulatory bodies is not enough. There needs to be a systemic solution, which begins with audit committees being discerning in setting audit quality metrics that audit firms need to meet before being engaged as statutory auditors. Audit committees need to annually test for auditor independence, as well have sufficient expertise to challenge auditors — rather than learn from them.

Audit firm too, must publish audit quality metrics for their firms; this as a practice is followed in global markets. Creating transparent metrics for measurement of audit quality and compelling their disclosure will perhaps be a big step in setting accountability.

Audit Quality Indicators

Audit quality is difficult to assess in its absolute terms, but there are indicators that can reduce the subjectivity involved in evaluating audit quality. AQIs are a set of qualitative and quantitative parameters to provide a basis for comparison across different audits and audit firms. AQIs can be defined at both engagement level (indicators related to the specific audit engagement) and audit firm level (indicators to gauge the audit firm’s overall focus on quality). Globally, several initiatives have been taken to outline such measures. For India, IiAS recommends the following metrics:

• Workforce metrics: These set of indicators enable the audit committee to judge the knowledge and experience levels of the audit firm personnel.
• Training: These metrics can be used to check the efforts undertaken by the audit firm towards skill-development and training of its audit team.
• Quality: These indicators highlight the quality of audit process and instances of audit deficiencies.
• Trends in audit metrics: These metrics may help the audit committee understand if fees and time involvement have grown in proportion to the complexity and volume of audit work.
• Legal: These indicators highlight the instances of litigation and penalties imposed by regulatory bodies on the audit firm.
• Independence: These indicators can be used to evaluate the independence of the audit team and steps taken by the audit firm in ensuring that the independence policy is not violated.
• Technology: These metrics indicate how well the audit firm understands the technology being used by the audit client, and leverages technology and analytics in audit execution.

 Hetal Dalal works at Institutional Investor Advisory Services India Limited (IiAS) and is a member of The Institute of Chartered Accountants of India. Twitter: @hetal_dalal. Views are personal.