How the audit profession can heal itself

The present crisis of confidence in the audit profession among users and stakeholders, arising from recent market events, has to be addressed in a fair manner. The profession, regulators and all concerned have to determine what the right medicine is.

A professional issue requires a professional response. Thus, the fundamental point is that the solution to the present expectation gap should come out from The Institute of Chartered Accountants of India itself. As a primary step, the government should empower the ICAI. The institute has done sterling work over the last six decades and yet, over the last decade, on certain basic matters like setting accounting standards or auditing standards, the government has created separate bodies (such as NACAS) with a superior degree of authority.

Changes in the syllabi of the institute have to go through a long process of governmental approval, when most of these are technical matters that the ICAI should solely deal with. It is the ICAI which has the wherewithal to understand what the professional issues involved are and it is they who should be in charge of the solution.

There are certain other myths about the possible solutions to the perceived ills of the auditing framework. I intend addressing a few of them.

Rotation of audit firms

Though this appears to be a very easy solution, essentially ensuring 'a fresh pair of eyes' is looking at the financials of a company every few years, implementation-wise this is not so simplistic. Among all the G-20 countries only Italy mandates firm rotation; it has been tried and abandoned by Spain, Brazil and Korea. The practical problem is that an auditor requires developing cumulative knowledge of the company to increase audit effectiveness, especially for very large companies straddling various countries and are multi-locational and multi-product producing. Rotation also increases costs.

By the time an auditor has invested and mastered the learning curve, it is time for someone new to come in and begin learning anew. In a country like India where more than 30 per cent of firms are sole proprietary firms, and a large majority of other firms are small/ medium practitioners who have since ages been serving their group of clients with admirable independence and integrity, rotation would ensure that all these firms would rotate out and thus loose their clients, without any surety of gaining new clientele, whereas for the very large practices, rotation would always end up increasing the number of audit clients.

Joint audits

Again, out of all the G-20 countries only France has a tradition of joint audits. Denmark abandoned this in 2005. In the Indian scenario, auditing standards governing a joint auditors' responsibility is very different from the global standards.

Globally, each joint auditor is responsible for the entire balance sheet but as per Indian standards each joint auditor is responsible for the work done by him. The reader of the balance sheet cannot ascertain which part of the work has been done by which firm and in a tricky scenario; gray areas and issues could easily obfuscate the efforts to determine liability for negligence.

Also, under the Indian scenario, it is possible for the management to cut and dice the areas of coverage by individual joint auditors in a manner in which the whole picture is not easily visible to any single audit firm. A classic example is the 'bank scams' of 1990-92 when more than 250 audit firms were prosecuted and perhaps no more than a handful found guilty. In fact, mandatory rotation, compulsory joint audits and appointment by a central agency could not prevent the large scale scam in the banking sector then.

Peer reviews

The best mechanism in the current context is strengthening and deepening peer reviews both by ICAI as well as other regulators. However, the pitfall is in the choice of the reviewers. For effective results, one must ensure that the reviewer has sufficient domain knowledge and experience of working with companies of a similar size and complexity. Otherwise, the very institution of peer review will soon lose its lustre.

Rigorous follow up and consequence management

The ICAI must ensure rigorous follow up and visible deterrent steps against any firm/individual violating professional ethics. The recent fast-paced steps taken by the ICAI are a positive indication that it is on the right track.

Oversight

India does not have any independent oversight board which is required for India to be treated at par with other developed countries. This is an EU-mandated requirement and, post 2010, will impact Indian auditors whose companies are listed in the EU.

Incidentally, India is the country with the largest number of firms in the world who audit more than 200 companies listed in various EU exchanges. An independent oversight body when formed could apply for membership of the IFIAR (International Forum of Independent Audit Regulators), thus, globally mainstreaming the Indian profession.

Last but not the least, we have to concentrate on costs of regulation and the size and materiality of the entities being regulated. In a very pragmatic move EU has recently proposed that entities with a balance sheet total equivalent to Rs 3 crore (Rs 30 million) net turnover upto Rs 6 crore (Rs 60 million) should be exempted from extensive reporting rules which are not in proportion to their accounting specific needs, create a cost burden and hinder the efficient use of capital. It is time our micro, small and medium enterprises ministry took similar initiatives for India.

Rahul Roy, director, Ernst & Young, India, can be contacted at rahul.roy@in.ey.com