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BW Businessworld

More Problems Than Solutions

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The audit profession in India was established well over a century ago, and many of the firms that are in existence today have rendered years of distinguished service to their clients. The accounting fraud at the erstwhile Satyam Computers brought into focus the long-standing relationship between companies and their auditors, and the breach of trust and responsibility that is placed in the auditor in his capacity as the “public watchdog”. This has resulted in additional regulation in a framework that has worked well for decades.
 
The Companies Bill, 2012 contains several clauses that are designed to increase the rigour in regulation of auditors. It calls for mandatory rotation of audit firms for listed companies, with a limit of two terms of five consecutive years. It also seeks to curtail the powers of Institute of Chartered Accountants of India (ICAI) as it proposes the formation of the National Financial Reporting Authority, which will monitor and enforce compliance with accounting and auditing standards, and have the power to investigate chartered accountants for misconduct. There will be severe penalties on audit firms that contravene independence rules, and punitive fines for professional misconduct ranging up to 10 times the fee received.
ROTATION NAUSEA

• Mandatory rotation destroys the knowledge base and understanding developed by the audit firm
• Italy’s Bocconi Report found that 40 per cent more hours are invested in the first year of an audit
• Rotation lessens effective and responsive working relationships between the auditor and the company
• Rotation would prompt auditors to build relationships that bring non-audit services after the rotation period
 
The issue of mandatory audit rotation is not new, and was first brought up more than 34 years ago in the US, where the Cohen Commission expressed concern that rotation would considerably increase the cost of audits, and that the benefits that investors might gain from mandatory rotation would be offset by the loss resulting from a continuing relationship. 
 
The more recent report of the General Accounting Office (US) in 2003 also concluded that mandatory audit firm rotation might not be the most efficient way to enhance auditor independence and audit quality. Several international academic studies emphasise that a significant number of financial frauds involve cases in which companies had recently changed their auditors.
 
It is not surprising, therefore, that only a handful of large countries, such as Turkey and Brazil, have prescribed mandatory rotation of audit firms after a predefined period. Some other countries, including Croatia, Latvia, Spain and Slovakia, introduced the same, only to reverse their positions after implementation of the regime revealed that rotation created more problems than it solved. In the UK, the Corporate Governance Code, 2012 wisely recommends tender of audits after a 10-year period, fully recognising that shareholders should have the right to choose the same firm of auditors if they are satisfied with the services they receive.
 
The issue is really audit quality, which, at its heart, is about delivering an appropriate professional opinion supported by necessary evidence and objective judgment. This requires auditors to build a culture based on integrity, invest in skills of their people, and continuously find new ways to increase the effectiveness of the audits in a difficult, fraud risk prone business environment. 
 
Apart from effective regulations, quality also depends on standards of education, ethical values of the society and swift enforcement of laws. For example, in India, the risk of corruption in business is a threat to audit quality, and that needs to be addressed. Moreover, excessive fines, penalties and regulation of the profession could drive away talent from the audit profession, and create severe capacity constraints.
 
From the company’s perspective, mandatory rotation is in direct conflict with the concept of consumer choice, and has the potential to increase costs. Company managements would face disruption, additional expense and transition time each time they change auditors, particularly if they have subsidiaries and operations across locations, and would run the risk of different interpretations of established accounting treatments. Companies raising capital would face the challenge of having to deal with two sets of auditors over the financial reporting period. In addition, the effort of taking on new engagements, the initial costs involved and the higher professional risks would increase the costs incurred by the audit companies, which will eventually be passed on to their clients.
 
In conclusion, excessive external regulation of the audit profession may not achieve its stated purpose of strengthening audit quality, but may instead result in muzzling of the watchdog. That does not help the dog bark.
  
The author is a practising chartered accountant.

Views expressed are personal.

(This story was published in Businessworld Issue Dated 31-12-2012)