A Few Roads Out Of This Audit Mess
Every corporate governance discussion in India starts with spreading the blame and ends with seeking new legal provisions to keep the errant and malafide in line. This one was different. Well, it started that way but ended with the four commentators — two auditors (one from the Big 4 and another a former ICAI President), one governance expert and one professor of finance and accounting — all agreeing that more regulation is not the answer — more competition is.
Let me tell you how we got here...
Satyam (2009) To IL&FS (2019): Have Auditors Not Learnt Anything?
Indian audit firms are facing a crisis of credibility. In the last two years there’s been an unusual spate of auditor resignations, with meager explanations, and insolvencies that came with no audit warning. Then in October 2018, infrastructure financing firm IL&FS Ltd. collapsed under the weight of Rs 90,000-crore debt. Much of this can be attributed to a complex structure of over 300 subsidiaries that masked rising leverage levels, an entrenched and corrupt management ‘coterie’, lending practices that flouted all regulations, and auditors that turned a blind eye.
The Serious Fraud Investigation Office’s investigation into IL&FS Financial Services Ltd., the financial services arm of IL&FS, documents management misdoings, faulty and fraudulent loan practices and auditor negligence (to put it mildly). It reads like a redux of the Satyam Computers Ltd. fraud.
The SFIO report finds that the auditors did not verify compliance with Reserve Bank of India’s rules on use of bank loans and non-convertible debentures. Instead, they relied on certificates issued by an accountant appointed by the management.
The auditors’ failure to report on end use of bank finances and NCDs allowed the company to divert public funds for prohibited purposes.SFIO Report in IL&FS Financial Services Ltd. case
Lending to group companies had been on the rise since financial year 2012-13, from 7 percent of total loans and advances to 37 percent. From Rs 463 crore to Rs 5,523 crore, the SFIO report finds. Even when it came to the evergreening of loans sanctioned by IL&FS and its group companies, the auditors were aware but did not raise the alarm.
Since the auditor had the knowledge of funding borrowers again and again for repayment and its adverse impact on financial statements, the auditor should not have relied on management representations.SFIO Report in IL&FS Financial Services Ltd. case
The SFIO report states that the auditors were aware of RBI’s negative comments on the net owned funds status, capital to risk-weighted assets ratio (CRAR) and funding of group companies by IL&FS, among other things, but treated these as “interpretation issues”.
IL&FS Financial Services (IFIN) was audited by Deloitte Haskins & Sells between FY09 - FY17 and also KPMG network firm BSR & Associates in FY18. In these 10 years the auditors raised no red flags, the SFIO report notes.
Last week the Ministry of Corporate Affairs filed applications in court to ban both firms for five years.
“The question is whether this is an epidemic of business failures or an epidemic of audit failures, asks Deloitte India Partner and Past Chairman, PR Ramesh.
He declined to comment on the specifics of the IL&FS case but makes two broader points. One, that business failures should not be equated with audit failures. And two, that audits are meant to certify financial statements as true and fair but public expectations have risen beyond that.
It’s been a common defense for auditors, and a partly valid one, that investors are expecting forensic examinations. It’s not the auditor’s job to sit in judgment of a company’s business decisions, is the common refrain.
But the IFIN auditors missed obvious red flags, says Amarjit Chopra, veteran auditor and former president of the Institute of Chartered Accountants of India (ICAI).
...I think the kind of evergreening of accounts that happened in IL&FS could have been avoided by a mere look at the entire position. I am not getting into the position of a judge. But the way the things have been brought out by the SFIO, I think there are certain basic things missing (in the audit) and for that I don’t think you need to be doing a forensic audit.Amarjit Chopra, Former President, ICAI
Is It A Big 4 Problem?
So now, Deloitte and KPMG firms are facing a potential five-year ban.
Earlier in June, the RBI barred EY network firm SR Batliboi & Co from doing statutory audits of banks for a year on account of “lapses in a statutory audit assignment”.
Last year, Securities and Exchange Board of India banned all PwC network firms in India from auditing listed companies for two years. The regulator also ordered disgorgement of Rs 13 crore from a PwC network firm and two partners. PwC was Satyam’s auditor.
To some it may seem as a crisis of credibility at the Big 4 firms. But the audit quality problem is widespread, insists Chopra. “This country has a non-performing loan level of almost Rs 11 lakh crore. If we see, all of those are not audited by the Big 4. Overall, auditing requires some kind of reform.”
And yet, the Big 4 have attracted most of the scrutiny and brickbats.
Size has one thing to do with it. The international brands have invested in aggregating several local firms into their network, investing funds in technology, training and marketing.
Concentration is another problem — the Big 4 audit 40 of the Nifty 50 companies and almost 300 of the Nifty 500 companies. They also command a 26 percent market share of audit fees across all listed companies in India, as per 2018 data. In the U.S. and U.K. they audit over 95 percent of companies listed on the S&P 500 and FTSE 350.
And then there’s conflict — these large global firms also provide a variety of advisory and consulting services. Often drawing allegations of compromised interests.
It is for these very reasons that in the U.K., the Competition and Markets Authority has proposed
- an operational split of the Big 4’s audit work
- mandatory joint audit, to increase the capacity of challengers
- regulator should hold audit committees more vigorously to account
Auditors should focus exclusively on producing the most challenging and objective audits, rather than being influenced by their much larger consultancy businesses.CMA Report
Too Big To Continue?
The problems of size and concentration make these firms to big to fail or jail, points out R Narayanaswamy, professor of finance and accounting at IIM, Bangalore.
About 25 years back there were more firms so there was natural competition but because of the mergers and acquisitions that have happened, there are fewer firms. So, now we have situation where there are firms which are too big to fail, they are also too big to regulate and also to jail. So, if they fail then there is big problem in economy as a whole.R Narayanaswamy, Professor of Finance and Accounting, IIM Bangalore
It’s time to break up the Big 4 in an effort to reduce the concentration and increase audit competition, says Anil Singhvi, former corporate leader and now founder of governance advisory firm IiAS.
According to me they are too big to continue. In fact, they should be broken into smaller firms. Instead of four, make them 12-15, but break them up. They got together and acquired all the local firms to become big four. So, this whole consolidation has resulted in a monopoly and the abuse of that monopoly. On one side, the audit fees have gone up, but on the other side, the quality and standards have gone down. At the receiving end, it is the investor who is providing the money.Anil Singhvi, Founder, IiAS
Chopra who has often championed the cause of smaller firms, as have most ICAI office bearers, past and present, agrees. Monopoly in any profession and any field is bad and so is the monopoly in the auditing profession, he says.
Let’s break up these four firms into smaller firms and let 2-4 firms not dominate any profession. The wisdom of no profession can lie in 4-5 firms.Amarjit Chopra, Former President, ICAI
Obviously Deloitte’s Ramesh doesn’t entirely agree. Concentration is not good, he concedes, but breaking up firms is not the solution.
It is not just about breaking the large and making them small. You need many more large firms. If businesses are large, you will need matching service providers. I concede that concentration is not good. We need 8-12 large firms.PR Ramesh, Partner and Past Chairman, Deloitte India
Achieving that is easier said than done.
Are Local Firms Up To The Challenge?
Over 700 firms audit India’s over 1,500 NSE- listed companies, shows data by Prime Database. But the Big 4 have the plum assignments.
Their market share declines from 80 percent of Nifty 50 companies to 60 percent of the Nifty 500 and 30 percent of all Nifty listed companies.
As the companies get smaller in size so does the audit fee.
That sets in motion a vicious cycle of low revenue, low investments, lack of scale. One that the large firms have countered with brand muscle and non-audit services.
Audit is not a very profitable thing, so you don’t want to audit and want to do something else - that is the start of the problem, explains Narayanaswamy. (Big) firms pitch low audit fees until they get in and start getting non-audit business but small (audit-only) firms don’t have those opportunities, he says.
That creates an un-level playing field.
Do only audit, in which case you will do full costing of the audit and full price of the audit services. So, I definitely feel that audit and non-audit should separate and that the transmission time should not be 10 years. I think in next three years the split has to happen.R Narayanaswamy, Professor of Finance and Accounting, IIM Bangalore
Time To Return To Audit-Only Firms?
There are many advocates across the world for a return to audit-only firms. Not just to mitigate size and concentration concerns or to help increase the scale of challenger firms, but also to counter any impact on auditor independence.
Company law safeguards against conflict of interest by listing services that a firm cannot, directly or indirectly, provide to its audit client, such as accounting, actuarial or investment banking services but crucially leaves out the two biggest sources of consulting fees. Tax advisory services and management consulting.
Attempts to provide quasi-legal services have elicited a warning from the Bar Council of India. More recently the Big 4 have also entered the insolvency resolution business. Prompting Singhvi to jibe — “ So, you first take company to liquidation (failure) and then you get appointed on it to see what can be salvaged out of this. This is a joke. We need to get out of this. A complete overhauling needs to be done.”
Mandatory Joint Audit?
Narayanaswamy too is in favour of pure audit firms. But Chopra recommends a graded approach. Of mandatory joint audits. To give challenger firms a chance to grow, as the U.K. CMA has proposed and to help improve audit quality.
Look at auditors of ONGC Ltd., Indian Oil Corporation Ltd. and all public sector banks. They are all joint auditors. There are questions among themselves. They actually debate over some of these issues. If there are conflicting views, then these are taken care of.Amarjit Chopra, Former President, ICAI
That gets voted down by the other two, Singhvi and Narayanaswamy, on concerns of friction, divided responsibility and blame games.
There’s one more solution on the table. This one from the Big 4 commentator. Give smaller, non-Big 4 firms a bigger share in incremental business. And encourage more consolidation among them.
One of the ways to recommend is that all new audits which come up are not necessarily taken up by the larger firms.PR Ramesh, Partner and Past Chairman, Deloitte India
There are more points to ponder in this debate on audit concentration and quality.
More Transparency: The Big 4 make no public disclosure of clients and revenue across various business activities as they are organised as partnerships. That makes it tough to gauge the size or depth of the problem.
Quality of Financial Reporting: Are all the additional disclosures that companies make as per law providing useful insight to investors on the state of affairs? Or is it a problem of the devil getting lost in the detail?
Speedier Punishment: The Satyam-PwC is still languishing at the Securities Appellate Tribunal. It will then go to the Supreme Court. 10 years have already passed. Another 10 may go by.
The Return of Spine: The same PwC recently stood up to a more power business leader and resigned as auditor from two of his companies, using a legal provision pertaining to fraud.
Watch the discussion with Anil Singhvi, Professor Narayanaswamy, Amarjit Chopra and PR Ramesh here below or read the transcript here.