Will Audit Rotation Have Unintended Consequences?

In about three years, India’s audit landscape will undergo a sea change. That is just putting it mildly. The new Companies Act, as it is now widely known, wants companies which have been audited by the same audit firm for at least 10 years to change their auditors within a transition period of three years. For Deloitte, India’s largest auditor, that is not just a number. The firm has, for decades, been auditing almost the entire gamut of of India’s most respected business groups like the Tatas and the Mahindras with hundreds of individual companies in each group. On the other end of the spectrum, the Mumbai-based Sharp and Tannan audits engineering behemoth Larsen & Toubro, its only major client, which contributes more than half it’s audit revenues.

 

This translates to low hanging fruit for the competition - the rest of the Big 4 - as they are collectively called – EY, PwC & KPMG (each having their own bunch of dedicated clientele, a chunk of which they are also slated to lose). Much of the support for mandatory auditor rotation came with the argument that it would make audits less concentrated. That is unlikely to happen for two reasons. Few firms in India have the resources to take up large sophisticated clients. Secondly, most investments come with a built in clause that mandates audit by one of the Big 4.

 

Adding to the woes of the auditors, the Rules to the Companies Act released recently close pretty much all scope for constructive interpretation. It says that the provision will be effective retrospectively, meaning longstanding auditors will have to be changed now, rather than after ten years. Again, it ensures compliance in spirit by disallowing firms and tossing out audit between firms within the same network. For example, PwC does its audits through any of the following firms - Price Waterhouse, Price Waterhouse & Co, Lovelock & Lewis or Dalal & Shah. But that won’t be permissible any more. Ditto is the case with the competition. 

 

From a universe of 3,002 listed companies, Deloitte and it’s network of firms audits the largest chunk, 181 companies earning a revenue of Rs 148 crore, according to a survey by Chennai-based Prime Academy titled ‘Who are India’s Top Auditors?’. The listed space is, one must remember, only indicative of the total revenues these firms earn. Their best clients, Indian arms of MNCs like a Coca Cola or a Citibank, are unlisted in India.

 

That poses challenges of it’s own. Global audit rules require that the auditor of the parent company ascertain that the subsidiary’s audit was carried out correctly. So for example Coca Cola, which has been audited around the world by EY since 1921, will now have to soon appoint a different firm in India. But EY may still have to go through Coca Cola India’s books for the purpose of the parent company’s audit report. This of course isn’t an India only problem. Netherlands has a maximum tenure of 8 years for auditors, while Italy gives nine. EU has given member firms to have their own tenure subject to a maximum of 10 years, while UK gives 20 years. But multinationals will have a tough job juggling audit firms according to each country’s tenure rules. Deepak Kapoor, chairman of the PwC network of entities, points out that globally, rotation of auditors where mandated, has been limited only to public interest entities (unlike in India where even private unlisted companies are covered).

 

Auditor rotation has been mandated in the new Companies Act as part of a clean up drive after the Satyam scam. The idea was to break any possible auditor-promoter nexus that was thought to be behind many scams going undiscovered. But could it have unintended consequences? “The concern is that rotation will eventually result in reduced fees paid by corporates,” says N Venkatram, who heads the audit practice at Deloitte. That is, when his audits become available for bidding by his competitors after three years, will they offer to reduce prices to get a competitive advantage among themselves.

 

The evidence certainly suggests so. In 2007-08, Bharti changed it’s auditors from Price Waterhouse to Ernst & Young. The total fees paid to the auditor declined from around Rs 10 crore to under Rs 4.45 crore. But Sudhir Soni, a partner in a member firm of Ernst & Young Global says that he does not see such a reduction going forward. “In view of significant changes to the regulations governing auditors such as mandatory rotation, increased reporting requirements such as internal financial controls and on fraud the cost of audit will increase”, he says.

 

What could happen is that firms will focus more on non-auditing services. “I may lose an audit client, but not necessarily a client of the firm,” says Deloitte’s Venkatram about the impending churn. The implication is that the thrust would now move to the much more lucrative non-audit space, mainly advisory, which under the new companies act, the auditor of a company cannot service (thereby benefiting a non-auditor).

 

Everybody sees the opportunity in the new Companies Act. For the big firms, it is the chance to poach companies that were so far loyal to their auditors. For the smaller firms, it presents a shot at getting into the big league in a bigger way. But are these real opportunities or simply castles in the air? Will market share come at the cost of profitability? And will quality of audits increase of reduce? What can be said for certain is that there will be a shake-up. How it will turn out eventually might require the skills of a game theorist to foretell.

 

 

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