An Effective Way To Make Auditors Effective
In the past few months all the ‘Big-Four’ members of the audit profession have found themselves in unwelcome limelight – either for resigning prematurely from audit assignments or because they have been punished by the regulators. Since PricewaterhouseCoopers was banned for two years from doing the audits of listed companies, the local member firms of Deloitte and of KPMG have been threatened with similiar punishment for their audits of Infrastructure Leasing & Financial Services. The local member firm of EY has been banned for a year from auditing any bank. This article addresses the issue of banning firms from carrying on auditing as a form of punishment.
Why have auditors been resigning in droves, citing lack of information and explanations as their reason? This is especially puzzling when they have been auditors for some time and there is no apparent change in circumstances that should lead them to such a decision. Why have there been so many audit failures, especially in audits of companies in the financial industries sector?
In several of these cases the ‘whole world’, except the auditors concerned, now claim to have been aware that all was not right. Why did auditors accept these clients?
A Few Roads Out Of This Audit Mess
The Need To Show ‘Growth’
The answer seems to be the capitalist measures of success: whose (practice) is the biggest? Who has the highest rate of growth? Who can claim association with the most prominent names? Audit partners and senior staff are recognised in their firms on these measures. Their compensation and their rise in seniority depend on their performance on these yardsticks, no matter how vehemently firms deny that this is so. After all, the other arms of a firm are measured on these same indices.
There is an impetus to take on fast-growing or prominent companies as clients and to then bend to accommodate their aggressive business practices when forming opinions on their financial performance.
Whilst the readers of the financials presume that the auditors have exercised conservatism in forming their opinions, they have, instead, incorporated management’s aggression into it.
The Pivot In 1976
In the Chartered Accountants Act, a negligent auditor was punished as an individual. There is no provision in that act for punishing the firm to which he or she belonged. The Institute could punish any member; it generally acted against the person who took responsibility for an audit assignment, the partner or partners who led the audit and, rarely, against Chartered Accountants who were part of the audit team. The logic for this was that negligence in forming an opinion on financial statements is ascribed to the individual who formed the opinion, a corporation does not form an opinion, less still can it be accused of doing so negligently.
Indeed, till about the 1970’s audit reports in India were signed as they are in most parts of the world even today – in the firm’s name.
But in 1976 the rules were changed to require that the name of the individual partner who signed the audit opinion must be disclosed in the opinion. This change recognised the individual responsibility for the opinion.
Over the years the perception of an auditor has changed from the individual to the corporate, not a little because of the enormous growth in their size as also because there are no colossi left in it, as there once were. The regulators too have been influenced by this change. Consequently, the new fashion for punishing the whole professional firm rather than the individuals responsible for misconduct.
Audit Firms: The Credibility Crisis
Such an action has meant seriously hurting a large number of innocent persons in the punished firm, who may have been diligent and honest in their work. They would be out of a job and the more junior they are, the harder would they be hurt. Besides, it punishes those other companies that have the punished firm as their auditor, leaving them to scramble to fill the void; regulators appear to have little understanding of the complications this causes to the company as also the great increase in risk of audit failure arising from the change.
Who To Punish And How
Given the way in which the profession has now developed, the punishment may be imposed on the following, based on their passive or active role in the acceptance of such a client, the quality of the audit work and the extent of accommodation to or connivance with the client, the diligence of the persons charged with oversight and culture:
- Obviously, the audit partners who signed-off or led the impugned audit. In large audits this would be more than one individual.
- Senior staff on those audits, whether Chartered Accountants or not.
- The independent partner who internally reviewed the work, but did not oversee its execution, and concurred in the final opinion.
- The partner who cleared acceptance of the client initially or on renewal of appointment.
- The partner responsible for quality control of the audit practice.
- The head of the audit practice of the firm.
- The committee of partners that determine compensation and promotion, including formulating the policies for that.
- The head of the firm. In many cases it is he who determines the culture in the firm.
Oftentimes, some of these individuals might not even be partners of the legal entity that is the auditor but may be in the overarching organisation with which the firm is associated. So, the head of the firm might not even be a chartered accountant and is CEO of the company that conducts consultancy work that is part of the same international or local cluster of related entities. Whilst many of the audit partners now accused of failure would have long been reluctant to accept certain companies as audit clients or to have given them a clean chit, it is pressure from the organisation’s culture that makes them succumb to malpractices. All the functions that are expected to ensure independent and good quality opinions or that can have a bad influence of the audit practice should be punished; not the rest of the audit practice.
That leaves two questions:
What of audit firms that do not have some of the internal quality functions?
They should not be permitted to do public interest audits.
What is the right punishment?
Get the individuals being punished to disgorge a major portion (or all) of their compensation in the years when the audit failure took place and ban them from any direct or indirect role in auditing or advising or being on the boards of listed companies. There could also be mandatory external monitoring of the audit practice for a period and restrictions on accepting new clients.
Nawshir Mirza is a professional independent director, and serves on the boards of a number of large Indian companies.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.