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There’s Something Rotten In The State Of Audits In India? Bah, Say Auditors.

“Earlier accounting and auditing had a lot to do with hindsight. Then to a great extent it moved from hindsight to insight. Now the issues which are coming up all relate to foresight. When I do regulatory inspections later, I can’t use hindsight to judge foresight.”

That, in a nutshell, describes why auditors in India believe they are facing flak from several quarters - shareholders, companies and regulators too. The job’s gotten tougher, the expectations higher and the liabilities more onerous say three of India’s top auditors - PR Ramesh, chairman of Deloitte India, Jamil Khatri, head of audit at BSR & Co - an affiliate of KPMG India, and Sudhir Soni, national leader at SR Batliboi - a network firm of EY. Also joining them in this BloombergQuint discussion was Nawshir Mirza, who serves as independent director and audit committee head on several boards.

It has been a tough year for auditors. A spate of resignations, a rap on knuckles by the Reserve Bank of India, enhanced liabilities in law and criticism from across the world on the concentration and conflict issues that beset the Big 4 in audit – EY, KPMG, Deloitte and PriceWaterhouse.

Watch the full discussion here or specific portions further below.

Auditor Resignation

Between January and July over 200 auditors resigned versus seven in all of last year. In some cases auditors resigned just before the end of financial year 2017-18. In most the explanations offered were sketchy. Leaving shareholders puzzled about the implications and doubtful regarding the veracity of earnings.

Auditors point out that there are many reasons why audit firms may be quicker to resign now than before.

  • SEBI’s two year audit ban on PW in the Satyam fraud case was a rude wake up call for all Indian auditors, who so far have rarely been penalised thus.
  • Meanwhile, enacted in 2013, the new companies law provided that in the case of fraud the liability would be of audit partners and the audit firm jointly.
  • The onset of the Insolvency and Bankruptcy Code, 2016 meant that in several cases forensic audits have been and may be conducted casting previous auditors in poor light.
  • When audit firm rotation kicked in, also a consequence of the new companies law, many firms rushed to grab clients only to regret some dodgy business acquisitions later.

Soni: This was the first year of audit rotation having kicked in and auditors were for the first time looking at some accounts. I feel that for some of these companies it was poor transition planning where you didn’t know some of the things you were getting into. I feel auditors and companies are equally responsible to ensure that there was a smooth transition.

What does it say about auditors if heightened liability has made them question the quality of some of the clients they are working with? Were you not questioning these clients earlier on?

Khatri: It is good that instead of playing along with management, auditors are saying that we will take action. If we are not comfortable with the company, we will move out of the company. In the past, they could have argued that under a similar set of circumstances the auditors would continue. But the fact that auditors are willing to stand up and say they no longer want to be associated with a company even after trying their best with audit committees and everybody, it is step in right direction from a governance perspective.

We need to focus on the reasons for the resignations. Investor interest will be well served when the reasons are well articulated, so that investors know what is going on. But on balance, it is an evolution. The fact that auditors are resigning is reflecting that people are becoming more conscious about their responsibilities.

In the past, when an auditor resigned it did not make news. The fact that an auditor resigning is making news is a step in the right direction because it means that the value of audit has gone up.

Isn’t it alarming that in some cases the audit firm worked with the company for several years, maybe since it went public, and yet decided to quit suddenly this year before the financial year ended?

Ramesh: It is unfortunate that the auditors are always blamed for such situations. What is incorrect is the expectation that what has happened in the past will always happen, even now, and happen in future. It is situational. If you don’t receive information today, you may have received information in the past, it doesn’t mean you are wrong today and were right in past.

When an auditor does not receive information, the auditing standards require him to withdraw from the engagement. So, he is complying with the standards even then the investors stand up and protest.

The law requires an explanation be given for auditor resignation. What is a reasonable expectation of a shareholder when it comes to the explanation provided by an auditor as to why he quit the audit? Often there is no hint at the materiality of the missing information.

Ramesh: Are you saying the auditor should provide investors a laundry list of items he has not received?

Khatri: I agree that it’s in everybody’s interest that an auditor puts out the real reason for why they are resigning. If we believe that improvement is required in that area then let’s provide regulatory clarity.

Mirza: When an auditor resigns he is obliged (by company law) to write a statement. Because there is a contract between the shareholders and the auditor. It is not a contract between the auditor and the regulator. What about the shareholder? Whatever I have read of these (resignation statements) they say cryptic, vague things.

Are auditors putting their own interests above shareholders? Are they protecting themselves, due to enhanced liabilities, instead of shareholders?

Mirza: They resign to protect their backs because they think this is not an audit they would like to sign off. Having protected their backs, they still have an obligation to tell the people with whom they have the contract. Shareholders appoint them to do an audit. You can’t tell the shareholders that the auditor is abandoning them without a reason. There is an obligation.
Shareholders have been hurt in several of these companies with the share prices collapsing. So that is a serious matter and the prices collapsed perhaps more than they needed to because no one knows how material the impact is. Perhaps if they had more information the prices would have behaved differently.

Also read: Complete The Audit And Disclose, Don’t Resign

Jet Accounting Confusion

Recently, one of India’s leading aviation companies, Jet Airways India Ltd. announced a delay in the reporting of its quarterly earnings. The delay was notified to the stock exchanges on the evening the earnings were to be reported. “It may be noted that the Audit Committee did not recommend the said financial results to the Board for its approval, pending closure of certain matters,” Jet said in its filing with the stock exchanges.

The next day its stock price fell sharply and Jet changed its tune. “Please note that since the management informed the Audit Committee that they needed more time to finalize the accounts…” it said in an explanation to the BSE leaving the exchange perplexed too.

When the earnings were announced there was no sign, no note, no explanation as to what had prompted the delay. What are shareholders supposed to do in such a case?

Mirza: They can’t do anything. All they can do is wait for an outcome. But you can ask what should the management and board be doing? Across the world, boards still don’t know how to deal with bad news. They try to downplay it, brush it under the carpet. I have no idea of Jet Airways specifically, but I assume that they were hoping and keeping their fingers crossed that till the last day they will have enough information to satisfy the audit committee.

Ramesh: Such situations do happen. It is not that it has not happened before. It is not that accounts and auditors are ready one week before. There are many times where in grave matters, particularly involving judgment, a lot of work happens at the end. At that time you find that you are not ready–meaning the auditor has not concluded or even the management is not fully able to provide sufficient evidence to convince an auditor or the audit committee. I don’t think there is anything wrong for the audit committee to say we won’t recommend these results and let’s take some more time.

Also read: Registrar Of Companies Receives Complaint Against Jet Airways, Seeks Response

RBI Rap On The Knuckles

In June, the Reserve Bank of India said it is putting in place a framework to take action against statutory auditors of scheduled commercial banks should lapses be found in the audit process. This was prompted by large divergences between bad loans accounted for by individual banks and as assessed by RBI. The divergences ranged from Rs 6,355 crore at Yes Bank Ltd. to Rs 23,000 crore at State Bank of India.

Is this new Enforcement Action Framework not a rap on the knuckles for auditors of banks?

Khatri: Even RBI, on its own provisioning norms, has evolved over time. In lots of cases, there was consultation with RBI on what is acceptable and not. Auditors have to make a judgment based on what the circulars were and based on that certain judgments were exercised. RBI is trying to send a message that if we find too many instances of this divergence then we will hold management accountable for not enforcing the circulars. Similarly, it’s telling auditors that there is a heightened sense of importance on this issue and therefore we would like you to be on guard. That if you do not hold management accountable then we will do this. So, this is an evolution of the entire regulatory framework. It is a step in right direction.

Soni: The RBI is saying that in these judgment areas, you need to be far more conservative and that is the sort of caution which is being provided.

Audit Quality Concerns Worldover

The problem with audit quality, whether perceived as auditors claim or real as shareholders believe, is an international one. In a report this year the International Forum of Independent Audit Regulators found accounting lapses in 40 percent of the 918 audits of listed public interest entities they inspected last year (2017).

The most common issue was a failure among auditors to “assess the reasonableness of assumptions”. The second biggest problem was that auditors failed to “sufficiently test the accuracy and completeness of data or reports produced by management”.

The same problems keep coming up? Yet auditors are unable to resolve them. Is it business complexity?

Mirza: Complexity is certainly a very important reason for some of the difficulties we have today and the challenges that auditors have in getting their heads around the complex kind of transactions which companies are now doing. That is one risk.

On accuracy and completeness of data that is an audit failure. If an auditor has not verified the accuracy and completeness, then it is a failing of the auditor.

But the failure to “assess the reasonableness of assumptions” is judgmental. When you look at a large number of complex businesses you may not be familiar with, to test the assumption you rely to a great degree on the management and to some extent on the audit committee. It is the failure of audit committees to find out what are the assumptions which are being used and to apply their own minds and judgments on whether those assumptions are reasonable or not.

British regulator, the Financial Reporting Council, in a report released this year noted a deterioration in audit quality at all the Big 4 firms.

Across the Big 4, the fall in quality is due to a number of factors, including a failure to challenge management and show appropriate scepticism across their audits, poorer results for audits of banks.
FRC Review 2018

This is about failure to challenge management not judgment. What explains that?

Ramesh: In the past there was lot to do with accounting and auditing in hindsight. Then to a great extent it moved from hindsight to insight. Now the issues which are coming up all relate to foresight. When I do regulatory inspections later, I can’t use hindsight to judge foresight.

If I were auditing a U.K. company and Brexit has happened–we could have completely different views on the implications of Brexit to that company. So, what is the right level of skepticism?

Khatri: We cannot shy away from the expectation going forward that auditors will need to challenge companies a lot more than they have done in past. From our perspective, we see this as a message. When it is an area of judgment we may have stopped at the first level. Now, the regulator is saying that your inspection needs to go to the second and third level. That’s what the regulator is expecting from us. That’s the rule of the game going forward.

One of the criticisms for regulators is also the way they define audit failures. In the U.S., the restatements which happened to accounts are at a 10-year low right now. But audit failures are at all-time high. Let’s say I have done a 40,000-hour audit and the regulator finds three hours of audit work where it believes control should have been tested in one manner and we did it in another manner, then it is an audit failure for the regulator. This is becoming a big issue across the world. People are saying that if regulators say 50 percent audits are failures, but restatements are at a 10-year low, it’s not stacking up. That is another dimension which we should bear in mind.

Conflict And Concentration

Several other factors, in India and across the world, contribute to audit quality issues. The problem of conflict of interest is a much discussed one. That audit firms also provide consulting and advisory services, all the Big 4 do, and often the Chinese walls between these functions are thin.

The IFIAR found that close to half the problems identified by audit regulators last year related to independence and ethics.

In India too the same problems exist. We just don’t have comparable data and analysis because for years we have dithered over the constitution of the NFRA.

Mirza: The pressure on audit leaders to win more business or more audit clients–that pressure is what makes them take on clients they later regret having taken on and they may resign after. What is the mechanism of that firm to reduce that pressure?

A head of one of the Big 4 once said to me that “I wish we never had an audit practice”. Because he saw them as an impediment to the progress and growth of the firm. And that pressure brings on their audit leadership, that you people are a pain in the neck for us, we get bad publicity, liabilities, and we can’t do a lot of other business because the rule says if you are an auditor you can’t do this.

Even if financially there is no mechanism any longer due to which auditors are being propelled in this particular manner, the fact is that you are in one family and you can still have these artificial walls but the reality is you are working in one group.

Ramesh: We are mixing things up in terms of when we are looking at audit partner compensation and audit quality. The auditor is the only one who is scrutinised the most in the firm. He is always under a spotlight. He is inspected by regulators and there are internal inspections. At the same time, management or the user does not perceive value from an audit as opposed to value from other functions. If I am handling a tax matter and save X dollars or X rupees, you will be more than willing to pay me a percentage of it because you are able to perceive value. It is not linked to audit quality but value. Audit quality has gone up.

“Crisis Of Confidence”
The FRC has minced no words to describe the magnitude of the conflict problem. “In some circles, there is a crisis of confidence,” said FRC chief executive Stephen Hadrill according to a Financial Times report.

Hadrill has called for Britain’s Competition and Markets Authority to investigate the case for “audit only” firms so as to resolve conflict issues and boost competition.

Then there’s the issue of concentration. The Big 4 audit 98 percent of FTSE 350 constituents. In the U.S., the figure is 99 percent of the S&P 500. In India, the Big 4 audit 60 percent of Nifty 500 companies.

Don’t conflict and concentration issues further hurt quality?

Ramesh: The inherent nature of a multi-disciplinary practice is critical for audit quality because of the support the auditor draws from other functions in a firm. In an audit-only firm, where will he go for tax advice, for technology support? Today, the auditor, unfortunately because the environment has changed, has to be tax savvy. Technology savvy.

Also an audit profession should mirror the constituency itself. If there are large industries the audit firm should be of commensurate size. You can’t have a mom and pop store serve the largest companies. Look at where we are today in the profession in India. We are 3,00,000 professionals, half of them are in practice. 50,000 are sole practitioners. And 1,000s of them are in partnership firms with very few partners and people.

Khatri: There are enough checks and balances on conflicts now. The amount of pressure on audit partners to sell non-audit work is no longer the way it used to be a few years ago. The prohibition on certain non-audit services is working in practice.

On multidisciplinary firms–out of the audit work we do today accounting and auditing knowledge is perhaps 60 percent of the knowledge required. Tax knowledge and IT knowledge is the rest. If you don’t understand that then you will not be able to audit.

Soni: We have to acknowledge that there is an issue around the world. India is not different from the world. Around the world, audit is in focus. People are looking at what the standards should be, how accountable auditors should be. The topics you’ve raised around conflict of interest etc, these are live topics around the world. I don’t think India is an exception to that conversation.

The auditors responses in this story are edited excerpts from the discussion. For the full debate watch the videos.