An important proposal for auditor reforms in India has been mooted by the Ministry of Corporate Affairs (MCA). The MCA has released a consultation paper in February 2020 highlighting the proposed changes in the audit practices. The consultation paper largely aims at revamping the practice of simultaneously carrying on audit and non-audit business by the large firms. The need to regulate the 'Big 4'(Deloitte, Ernst Young, KPMG, and Pricewaterhouse Coopers.) accountancy firms are specifically noted. Post the Satyam audit scandal, the Indian regulatory attempt to revamp the external audit process was evident in the Companies Act, 2013. The new proposal by MCA forms the second wave of audit practice reform in India.
What was the audit reforms under the Companies Act,2013?
In the Satyam case, the fudging up of the account book was not pointed out by the Pricewaterhouse Coopers as an auditor. The major problem that needs to be addressed post- Satyam crisis is the possibility of unholy nexus of the external auditor and the promoter/management of the firm. Moreover, the possibility of nexus between the promoter and the auditor was never regulated through the erstwhile Companies Act, 1956. Even though the proposal for reform was planned post- Enron scandal, the slow wheel of policy-making could not adequately address any reform.
The need for mandatory switching and rotation of the regulator is an important change prescribed by the Companies Act, 2013. The Companies Act 2013 had also proposed for the National Financial Reporting Authority, which now is functional as an institutional mechanism. The corporate accountability and transparency were aimed to be scaled up by this measure. The Oxford Business Blog article by Saumya Bhargava highlights the role of corporate scandals of Fortis Healthcare and Punjab National Bank as a possible explainer for the swift adoption of the National Financial Reporting Authority. In this context, the Fortis Healthcare Services Limited group was under scrutiny for allegedly not following the accounting standards. The auditor supposedly overlooked the Indian accounting standard requirement.
Are the proposed audit reforms required?
In the Indian context, the MCA consultation paper outlines conflict of interest issues such as "self-interest threat due to reliance of auditor on the fee from the client". Self- interest threat also comes to picture in a scenario where "the audit firms want to hold on to clients after the completion of auditing assignments, in order to provide other services (like management consulting, book keeping etc)." Here again, the accountability and transparency of the auditor may be questioned. Auditors are identified as gatekeepers of corporate governance. The audit industry is very similar to the credit rating industry which is also marred with the issue of conflict of interest.
The MCA consultation paper goes on to identify other conflicts of interest scenarios such as self-review threat (affects the independence of the auditor if the auditor is auditing his or own work or work that is done by others in the same firm); Advocacy threat ("the auditors involve in promoting the client to the point in which their objectivity is potentially compromised"); Familiarity threat ("if the auditor is either too familiar with employees, officers, and directors, or keeps a long-standing relationship with the client ); and Intimidation threat ("auditor is intimidated by management or its directors to the point that they are deterred from acting objectively").
A series of stringent regulatory measures are proposed to ensure the audit independence could be maintained. For example, to the rectify the self-interest threat the following measures are proposed in the MCA consultation paper:
- Prohibition of providing non-audit services;
- Fees based on reasonable estimates of time and expertise required;
- Stringent independence guidelines and monitoring by firms;
- Disclosure of previous business relationship with the company in audit report;
- Legislative restrictions on auditors regarding independence.
Moreover, the proposal also highlights the significant economic concentration of the Big 4 audit firms. This could also lead to a situation where the mandatory rotation of the auditor firm is not an effective measure to induce independence of functioning. The United Kingdom competition regulator has noted the need for regulating the non-audit work done by the Big 4 auditors. This is in light of the possible conflict of interest and the promotion of the business at the cost of sacrificing the independence. The business ethics requirement may also be considered as a major reason for the proposed change to be brought in. In the Indian context, MCA proposes for joint audit as a measure for reducing the influence of Big 4 firms. Moreover, the possibility of a competent regulator selecting the auditor is seen as a possible option. Ramping up the audit capacity of the mid-size and smaller Indian audit firms is also emphasized.
The IL&FS and the Jet Airways crisis have placed the audit firms in India in a precarious position. The MCA proposal for audit reforms is a regulatory reaction to the alleged lack of audit quality. But the question of whether the MCA proposal takes it to the level of over-regulation is expressed by corporate law scholar Umakanth. Stringent regulations proposed could adversely hamper the audit industry. Moreover, the proposed regulation could have envisaged to revamp the regulatory power of the National Financial Reporting Authority. At present how, the National Financial Reporting Authority as an institutional mechanism is neglected in the reform proposal. Moreover, a comprehensive understanding of how a civil liability framework could be envisaged for the erring auditors. Allowing a wider jurisdiction for stakeholders to initiate the civil liability litigation against auditors would also be a point worth considering. From the regulatory governance perspective, it is significant to note that responsive regulation is an important goal that needs to be aimed while designing the regulation.
The author is faculty at IIM Kozhikode and can be reached at email@example.com . Views expressed are personal