Who trusts the Auditors?

Sibichen K Mathew

                                                

                      How many of you evaluate the past performance and future prospects of a company before investing in its shares? We go by the popular perception, public profile of that company, or the ‘hype’ created by the company itself! The media, the consultants, the specialists and the advisors suggest the best deals to the potential investors. All of them give their views on the basis of the financial statements and audit reports of the company. That means, investors trust the audit reports. To put it simply, ‘people trust the auditors’!

                 Contracts are entered, money is lent, job offers are accepted, tax incentives are given, and above all ‘social recognition’ is bestowed on many corporates on the basis of a beautiful (well-dressed) balance sheet amply certified by auditors. 

                 Yes, we - the government, the investors, the lenders, the purchasers, the sellers, the service providers, the taxmen, the employees, the public - means, the entire society, repose faith in the auditors! And the auditors are supposed to vouch, examine, evaluate and certify the correctness or otherwise of the transactions of the company and its orientation. 

               Yet,  we hear well-established companies bursting like bubbles, share prices reaching rock bottom, promoters fleeing the scene, top management going behind the bars, and all stake holders watching everything helplessly!

What was wrong? Why these happenings?

                Audit, all over the world, is a powerful instrument to ensure accountability and financial regularity in all types of institutions and organizations. Though millions of investors rely on corporate audits, the recent corporate scandals all over the world have raised serious questions about the efficiency and effectiveness of corporate audit regulations and enforcement. The audit report is a powerful indicator of a company’s financial stability, accounting consistency and reliability. However, everything depends on how efficiently the audit was done and how clearly the transactions are reported in the audit report.

                   The Lehman BankruptcyExaminer’s Report  has come down heavily on the failure of Ernst & Young in preventing one of the biggest failures in the Wall Street that triggered global recession. Audit and accounting failures were also evident in the cases of BAE Systems , Olympus , Enron , World Com , Lucent Technologies , Sun Beam Corporation , Waste Management , Boston Chicken  etc. India has also witnessed a series of financial scams in the last decade especially during the liberalization period, most of which are rooted at accounting frauds. However, the responsibility of the auditors in these scams and their role in frauds are never viewed seriously.  Reserve Bank of India has a long list of companies who have been guilty of unethical accounting practices and diverted public funds. A number of companies vanished with crores of rupees immediately after the public issue. Financial statements of several companies became unreliable and depicted wrong state of affairs.Satyam scam is the best example.

The Problem areas

                The corporate scams and scandals happened in the world in the last few years are clear indications of the collusion between auditors and management in accounting frauds. They have happened either through active suggestions and consultancy to commit frauds or through deliberate omissions in the job. Inefficiency and technical incompetence of the auditors have resulted in some of the corporate debacles. It is foolish if one refuses to learn any lesson from the above scandals, thinking that these are just aberrations and will not recur.

                      In many cases it is seen that the audit firm is unduly dependent on the client financially. It may be due to the fact that the audit firm provides bulk of its resources for that client or it receives substantial amount of its earnings from that particular client. Thus it is a question of survival for the firm. It results in subjectivity in the performance and reporting of the auditor. In spite of strict codes of conduct, many auditors enter into financial transactions in the names of relatives with the client or the client’s associated concerns. There are also beneficial interest in trusts of the clients, and in shares and investments in associated concerns and also employment of close relatives in connected concerns and re-employment by the auditors in the clients’ concerns. Most of the audit firms involve in the non-audit work of their clients and they receive substantial portion of their earnings from such non-audit activities. The share of management consultancy in the total revenues of the top five chartered accountant firms in US, has gone up from 13% in 1981 to more than 50% by 2010.

Responses of the regulators and intra-disciplinary bodies

                     Sarbanes-Oxley (SOX) Act , is the US authorities’ response to political outrage in the wake of Enron, WorldCom, and other equally shocking failures of law, standards, governance and audit. SOX Act is considered as the legislation, which brought most sweeping changes to securities law, corporate governance, and the regulation of auditors since the Securities Exchange Act of 1934 . The SOX Act has international implications since the auditors of overseas subsidiaries or associates of US listed companies are obliged to sign up to it if they wish to retain the work. SOX Act laid down an array of strictures on company directors, especially CEOs and CFOs. Failure to comply could mean prison terms of upto 25 years.  The creation of the self regulatory board of Public Companies Accounting Oversight Board (PCAOB)  by the US Congress through the Sarbanes-Oxley Act 2002, was meant to give powers to the Board over the external auditors in order to guide them in auditing the public led companies. Though there are enough laws, the institutional mechanisms in India and many countries are marred by weak enforcement.

Need for a global policy 

                    In this era of globalization and transnational character of businesses, it is necessary to have effective global standards in accounting and auditing. The guidelines need to be uniform. However, the procedures can be flexible based on the particular country’s requirement, without compromising the fundamental principles. 

                 What is imperative today is the establishment of an International Quality Assurance Body that formulates universalistic principles and guidelines for all accounting, auditing and consulting firms all over the world. The body should suggest an appropriate mechanism that ensures quality, reliability and objectivity among audit firms. It is also necessary to have concerted action to prohibit direct or indirect monopoly in the area of auditing and consulting by a few firms. Proper auditor rotation, disciplinary mechanism, and an environment that ensures auditor independence can bring back public trust on the auditors.

You may also like to read following related articles:

Satyam: A case of worst audit failure

Frauds, Scams and a Corporate Lokpal

 

 

Frauds, Scams and a Corporate Lokpal

       Anna Hazare and his people’s movement against bureaucratic and political corruption gained massive support from the public from all walks of life in India. Along with bureaucratic and political corruption, the corporate corruption is also thriving worldwide.    

    It is a fact that high level political and bureaucratic corruptions are facilitated by a cross section of corporates. Almost all the major scams in various countries and particularly in India are through direct or indirect involvement of big business enterprises. Apart from the scams and frauds that are products of an unholy nexus of businessmen, bureaucrats and politicians, many companies, large and small, are marred by corruption within itself. This results in large scale diversion of funds and inefficiency which invariably affect the interest of all external stakeholders.

    Corporate corruption has further strengthened the parallel economy, by moving from the conventional practice of ‘black and white’ transactions to Special Purpose Vehicles and sub-contracts giving a colour of legitimacy to the deals. Such unethical practices have resulted into companies becoming bankrupt and investors losing quite heavily. 

   In an interview reportedly to the Press Trust of India, the Chief Vigilance Commissioner of India said that Corporates may be brought under the purview of Lokpal. However, an amendment proposed by opposition MPs in Indian Parliament to include corporates within the ambit of Lokpal was defeated during a special parliamentary session convened exclusively for passing the Lokpal Bill. At this juncture, one needs to think loudly for an effective watchdog to check corporate corruption.

  The market regulator Sebi has finally woken up to advocate for the expeditious creation of an independent audit regulator in India. The demand for such a regulator to oversee the audits has come in the backdrop of increasing awareness about the dwindling standards of corporate audits in the country.  The lack of effective disciplinary action by the Institute of Chartered Accountants of India (ICAI) has also prompted the regulatory bodies and others to think about the need for an independent regulator. Interestingly, but not certain whether it is an immediate reaction, the ICAI has reportedly barred two auditors of an Indian audit firm  from practicing for life and slapped a penalty of Rupees 5 lakhs each on them for their role in the 14000-crore Satyam scam. A probe by an ICAI disciplinary committee has found the above two chartered accountants guilty of professional misconduct while their firm conducted audits on behalf the PWC. The action of the ICAI came as a surprise for many as all along the statutory body maintained a position that what happened in Satyam is not an audit failure but a corporate governance failure. Be that it may, the series of corporate scams and scandals happening in the recent years point towards the deficiencies in the current audit system.

      

          Indian laws are not without any provisions to tackle offences by the auditors. The new Company’s Act provides for certain situations in which the auditors can be held responsible for negligence, incorrect statements etc.   Apart from the mechanisms of SEBI and Company Law Board, there are internal control mechanisms in the profession through ICAI. However such measures did not create any serious impact in the profession as the deterrence mechanism is very weak. The present powers and responsibilities of the audit committee are unlimited. Members of the Audit committees of many companies lack technical competence and fail in their role as an effective investigator and evaluator.

‘Auditor Independence’- Is it impossible in the current structure?

  Analysis of the corporate audits in India indicates that the auditor independence has been compromised due to several reasons as mentioned earlier. The problems lie in several areas: Appointment of auditors, payment of fee, audit and non-audit revenues, the threat of loss of contract, self interests, cultural and primordial preferences while appointing auditors, lack of technical competence, financial and non-financial relationships with the clients etc. Added to the above there are problems of lack of uniform and objective standards, disciplinary authority, over sight bodies etc. In the above circumstances it is necessary to think in the direction of making some radical changes.

Can we have an Independent Audit Regulatory Authority?

 As we seen in our discussion and review , there is a necessity for a strong  institution to oversee the entire audit work in the country. The set up should have certain necessary attributes. It should be independent, technically competent, representative, multi functional, and with sufficient legal powers. It may be headed by an Auditor General who is nominated by the President of India and should be a constitutional authority with a fixed tenure of at least 10 years. This would make them totally independent of the changing governments in the country. The post should be made constitutional and removal be made only through impeachment.

Following structure is suggested for the above authority. The structure consists of various autonomous boards with independent functions as given below.

INDEPENDENT AUDITOR GENERAL (Reporting to President; Assisted by chairmen of the  following independent bodies)
AUDIT BOARD (Power over both public and private sector without any differential treatment; Chairmen of following independent bodies are members, fixed tenure)
STANDARDS BOARD (Responsible for formulating and amending standards)	QUALITY REVIEW AND INSPECTION BOARD (oversight board which reviews the audit work and conduct inspections)	DISCIPLINARY BOARD Enquiries on misconduct of auditors, Initiation of disciplinary  proceedings, and Decisions (Separate entities for each functions)	AUDITOR ALLOCATION BOARD Centralized empanelment of auditors –specialization wise and region wise based on set criteria. Allocation through random allotment from a list of ten preferences given by the client as well as the audit firm) Appointment for 5 years without any extension.	GRIEVANCE BOARD Dealing with grievances on Standards, procedures, reviews, inspection, auditor allocation , disciplinary proceedings etc) But appeals against disciplinary action imposed lies only with Audit board

           As seen above, the independent body can oversee streamlining of the accounting standards. Though ICAI has been successfully involved in the preparation of accounting standards, lately arguments have emerged questioning the ‘objectivity’ and ‘independence’ of the ICAI. The role given to ICAI was only for a limited period till such time the central government constitutes an autonomous body to prepare the standards. Since most of the problems related to ‘auditors independence’ is because of the current system of appointment of auditors, the independent authority can be in charge of empanelment and allocation of auditors. As we entered the phase of competitive business management there should not be any distinction between the standards for private sector and public sector. Both should be under the purview of this structure.

 Suggestion for National  Audit Fund

   It is seen that the independence of auditors are affected because of their dependence on the clients for fee. Therefore a National Audit Fund can be created to take care of the auditing expenditure. The entire expenditure for auditing (the audit fee and other audit expenditure for the auditors) should be borne by the Auditor General Office. Fund can be raised through one or all of the following sources: a) Portion of annual fee by companies, b) A very small portion of the investment of each investor c) a fee proportionate to their annual turnover, and d) Amounts collected as penalties and fines.

Conclusion

  The public responsibility of auditors as watchdog of companies is very crucial for overall stability and financial discipline in the economy and business. Most of the corporate failures in India and abroad pointed out the ‘audit failures’ in many companies. It is seen that the independence of auditors are under serious threat due to several factors. There is a need for an independent authority to effectively regulate and enforce the audit system in India. The authority should be totally independent of the government and would have uniform standards for both public and private sector. However no authority can be a panacea unless companies and audit firms understand that internal control, personal competency and ethics play crucial role in making the institution more efficient and socially productive.

You may also like to read Satyam: A case of worst audit failure