Improving Audit Quality: Significance of Independence and Capacity Building
“In the last 20 years, a series of spectacular scams namely Satyam, Global Trust Bank, ILFS, King Fisher, Yes Bank, Dewan Housing Finance Ltd., CG Power Systems etc. hit the economy, disrupting the financial ecosystem. Amongst the trending stories was the Punjab and Maharashtra Cooperative (PMC) Bank, which drew social media attention and ire. Nevertheless, it appears that the voices of the ill-fated depositors are still unheard in the corridors of power. Even Twenty-One months later, the crisis remains unresolved. Read on…”
1 Economic Governance, Scams, and the Regulatory Landscape
Joy Thomas, Managing Director of the beleaguered bank, in his five-page letter to the Reserve Bank of India dated 21st September 2019, confessed the role of top management, including a few board members, in hiding the actual NPA numbers and the real exposure to the bankrupt HDIL. He also blamed the auditors for “superficially auditing” the lender’s books due to time constraints.
Though Chanakya primarily espoused the idea of economic governance in India in Kautilya’s Arthashastra, it went through a series of evolution over the last few decades. Each scam contributed to strengthening the corporate governance framework of the respective nation. Although it’s practically impossible to eliminate all the threat factors, mitigation strategies are provided both in the statute(s) and the individual organizations. Technology, on the other hand, is acting as a double-edged sword. With the advent of sophisticated detection tool and technique, the scandals are also carried out with the same high-end technology posing unprecedented challenges to enforcement agencies.
The government and investors demand more transparency in the overall conduct of affairs. An element of skepticism has become a default factor during the business performance evaluation. The more robust the governance mechanism, the better is the reliance quotient reposed in the management. It’s in this context, the role of independent auditors and directors assumes significance. While the Auditor plays a watchdog role, the Independent Director (ID) acts as a trustee for the shareholders. Both challenge the management responsible for the day-to-day affairs on governance-related matters. While this looks simple on paper, its execution is not that easy due to internal and external factors.
“The government and investors demand more transparency in the overall conduct of affairs. An element of skepticism has become a default factor during the business performance evaluation.”
2 Threats and Safeguards to Auditor Independence
We now get down to dwell upon the threats and safeguards to the independence of the Auditor. Threats to independence and safeguard measures of auditors are enshrined in the ICAI guidelines. According to the International Federation of Accountants (IFAC), there are five threats:
These factors are common to all geographies and capable of being adopted without country-specific customization. These threats are unfortunately not easy to safeguard. Theoretically an auditor is appointed by shareholders. However, practically auditors are appointed by a dominant group. Intimidation threat impairs the independence of the auditor to an extent.
ICAI Recommended Guiding Principles
- For the public to have confidence in audit quality, auditors must appear to be independent of the auditing entities.
- The Auditor should possess integrity, objectivity and professional skepticism, all of which are prerequisites to independence.
- Before taking on any work, he must conscientiously consider whether it would involve threats to his independence. If he finds any, he should either desist from the task or, at the very least, put in place safeguards that eliminate those threats. All such precaution measures need to be recorded in a form that can serve as evidence of compliance with due process. If the Auditor cannot fully implement reasonable and adequate safeguards, he must not accept the work.
Statutory Prescriptions under the Companies Act
Apart from the Chartered Accountants Act and Regulations, the Companies Act provides prescriptive measures to ensure independence:
- Disqualifications on Appointment (Section 141): Restricts appointments where conflicts exist.
- Prohibition of Non-Audit Services (Section 144): Prohibits certain services to audit clients to eliminate/mitigate conflict of interest.
- Removal of Existing Auditors: Mandates prior approval of the Regional Director to safeguard auditors against arbitrary dismissals.
Against this backdrop, there are adequate legal provisions, guidelines and code of conduct for safeguarding independence. Independence being a state of mind, is not affected by a relationship. However, appearing independent is as crucial as being independent. According to ICAI, in any case, where there is a feeling in the public mind that the close relationship of the Auditor with the management would affect the independence of Auditor, the auditor should use his good sense and refrain from accepting the appointment. The CA should ensure its independence in all assurance services, including concurrent audit, tax audit, and internal audit. Needless to say that independence ensures free and frank expression of opinion/reporting.
3 Regulator-Led Appointments for Public Interest Entities (PIEs)
“To improve the quality of reporting there is a need to free the Auditor from the intimidation of removal and to ensure all such measures to eliminate risk of conflict of interest.”
We are of the opinion that to improve the quality of reporting there is a need to free the Auditor from the intimidation of removal and to ensure all such measures to eliminate risk of conflict of interest. Laying down a process to ensure appointment of Auditors by an independent agency other than the management, at least in case of Public Interest Entities (PIEs), is key to provide independence to Auditors. We in no way are trying to belittle the performance of Auditors so far. But what we are trying to advocate is a process which is likely to improve the quality of audit and consequently the reporting by Auditors.
Appointments of Auditors in PIEs be made by any of the regulators viz. SEBI / MCA / RBI / IRDA depending upon the entities being regulated by each one of them. It is a bit disappointing that none of the regulators is willing to take up this responsibility. In our opinion irrespective of practices worldwide, India may take the lead in this to enhance quality of audit and consequently the credibility of auditing profession.
In the recent times it is being generally perceived that there is a need to restrict non audit services being rendered to an audit client by Auditors. Rather, there has been a sense of feeling that there is a need to ensure this control to operate at network level rather at firm level alone. UK has already taken a lead in this matter by requiring bigger firms to segregate audit and non-audit services effective 2024.
4 Joint Audits, Monopolies, and Level Playing Field
In India a view has been emerging that probably it would be better to have more than one pair of eyes to scrutinize the financial statements as Auditors. Though there is no empirical evidence to prove that Joint Audit concept is more efficient, yet it is believed that having more than one auditing firm could provide an opportunity for auditing matters to be discussed and concluded by representatives of more than one firm. There has been opposition to the concept of Joint Audit from certain quarters for lack of empirical evidence to prove its superiority. According to them, it may even lead to situations wherein different auditors may not be able to come to unanimity on certain issues. However, it may not be out of place to mention that concept of Joint Audit has worked very well in audit of public sector banks (PSBs) and other public sector undertakings (PSUs).
It is also felt that monopolies in general are bad in any sector and our profession is no exception to this. The need for reduction in concentration of audits and other professional work in few hands is well recognized. We are of the opinion that there must be level playing field for all players in profession. We do recognize that profession cannot be run on socialistic pattern of society. But at the same time, it needs to be recognized that tenders floated by government departments and various entities should not be tailor made and skewed heavily in favour of certain firms alone. This has certainly hampered the development of Indian firms. Time is ripe to speak up for small and medium sized firms willing to move to next stage. Reduction in concentration of audit work will certainly encourage Indian firms to invest in technology and to prove that these are second to none in performance.
“But at the same time, it needs to be recognized that tenders floated by government departments and various entities should not be tailor made and skewed heavily in favour of certain firms alone.”
5 RBI’s Groundbreaking Auditor Appointment Norms
The RBI’s new norms for appointment of auditors have created a buzz in the financial circles. We appreciate the regulator for its commendable measures. RBI has brought far reaching changes in the rules with regard to capping of number of audit appointments in entities regulated by it:
- Tenure Reduction: Period for which an Auditor can continue has been reduced to three years.
- Six-Year Cooling Period: Introduced a cooling period of six years after a term of three years’ audit of an entity.
- Group-Wide Non-Audit Ban: Restricted auditors from accepting any non-audit services in any regulated entity of the same group.
- Network-Level Applicability: Most importantly, all these new norms have been introduced at network level rather than the firm level.
- Mandatory Joint Audit: Stipulates Joint Audit in regulated entities beyond a specified threshold limit.
- Conflict Disclosures: Prescribes factors like exposure of regulated entities to certain clients of proposed auditors to be considered by Audit Committees while determining independence.
Implementation Challenges of RBI Norms
In our view, the implementation of the new norms could throw a few challenges:
- First, the audit committee will have to select the auditors, ensuring auditor’s independence appropriately, laying down objective criteria.
- Another challenge relates to compliance timelines due to cessation of term after three years (compared to earlier 5 years).
- Capping on the number of appointments that a firm and firms in the same network can accept will create vacancies—good news for medium-sized Indian firms, but causing hardship to firms whose tenure gets curtailed.
Recently, SEBI has made it mandatory for an auditor who resigns to give reasons for resignation. MCA is also looking at making it mandatory for the resigning auditor to give the correct reason for resignation. This is one more step to ensure independence of auditors. The new rules are applicable from FY 2021-22 (non-bank lenders may adopt from H2, but banks face immediate compliance).
RBI has done its job bringing in the concept of Joint Audit. In our view, this needs to be extended to all PIEs. While a Joint Audit by itself may not do a miracle, there is inbuilt merit when a second pair of eyes is deployed to enhance objectivity and quality of the opinion-making process. In the event of disagreement between joint auditors, both are required to come to a common point which both subscribe.
6 Capacity Building and Level Playing Field for Indian Firms
It hardly needs be emphasised that there is a need to build capacities of Indian firms. ICAI has been making efforts to enhance technical skills of members through continuing education programmes. Also various specialised post qualification courses have been introduced to promote specialisation in areas like Forensic Audit, Concurrent Audit of Banks, Ind AS, International Taxation, Valuation Services and so on. Recently, networking guidelines have been revised.
ICAI needs to create opportunities for members to ensure utilisation of specialised skills appropriately. For this it may be important to have a dialogue with government agencies and various regulators to allow tendering by networks of small and medium sized firms. This would allow these firms to come together and pool their resources and invest in resources including technology which ultimately will improve the quality of audit and other professional work undertaken by such firms.
A vital takeaway is that this is a step towards providing a level playing field between Indian origin and other firms having global networks. For several reasons, Indian firms have been marginalized in having their share of the pie in the profession by losing grounds to the Indian arms of large MNC firms. The widely advocated argument is Indian firms lack techno-investment. This charge may be partially true, but the solution lies in giving them opportunities they deserve on merits rather than sidelining through systematic approaches. Often the government agencies play a crucial role in such act of skepticism antagonism. This practice must stop in the more considerable interest concerning all stakeholders.
Many accomplished and astute members are practicing through Indian firms who have demonstrated skills par excellence. We appeal to all Indian firms to consolidate, infuse technology, and improve overall audit infrastructure to achieve the profession’s aspiration. Whatever RBI has done is commendable. But as they say, “Yeh Dil Maange More”.