Ensuring compliance

The traditional role of an auditor was as a check instituted by the shareholders, upon the directors. It was because the company form of business, for the first time, separated the ownership from the management. An audit ensured the flow of adequate and accurate information from the management (the Board of Directors) to the owners (the shareholders).

But open any textbook and the role of the auditor today is much wider. He's responsible towards a wide variety of stakeholders such as shareholders, creditors, lenders, banks, financial institutions, government etc. The auditor is still appointed by the shareholders, even though he dons a completely new role. There is a mismatch between the appointment process and the expected role. An auditor appointed by the shareholders would end up being responsible only to the shareholders — and not to the stakeholders as he is expected to be. But the selection is not even done by the shareholders. The shareholders merely approve the name recommended by the board. The power to choose whether to appoint X or Y effectively rests with the management. The shareholders then rubber stamp that

choice. If there is ever enough support to reject the auditor, the shareholders would probably first replace the board and we're back to the same problem.

There's another problem. The management often does not consider audit as a value additive process. Instead of a powerful risk management tool, it may be viewed as a 'mere formality' in their eyes. As a result, audit fees are usually very low compared to the responsibility involved.

We see two distinct problems here — one, the conflict of interest in the selection of the auditor by the management and his responsibility to a wide variety of stakeholders, and two, the low fees for an audit that the management is willing to give for the statutory audit. The only real income of an auditor is from the allied services, for which they are, yet again, dependent on the management. Ethical pledges cannot overcome economic incentives. The only way to make it work is to align the financial interests of the auditor with his expected role. We need a better way of appointing auditors and determining their fees.

The auditor can be appointed using a simple and transparent mechanism giving little discretion to anyone. A points-based matching mechanism is proposed. Smaller firms will get more points for smaller companies. Experienced firms with more partners will get higher points for audits of companies with greater capitals or revenues. Firms located closer to the Head Office of the company will get higher points. Experience of auditing FMCG companies will count towards FMCG audits. Firms having fewer existing audits will get more points since they can devote more time to the proposed assignment. Considering these and other criteria, a composite score will be calculated indicating the most suitable firms for auditing a particular company. From the list of say top 10 or 15 firms (based on the points), one firm can be randomly selected.

The exact set of rules to be used can be decided by the National Financial Regulatory Authority (NFRA). These would need to be periodically reviewed based on the feedback received. The design must take into account attempts at gaming the system such as creating multiple firms, engaging shadow partners etc., which will almost certainly take place. If multiple firms from the same network apply, only one of them will be shortlisted. The random selection from within the shortlisted firms will ensure that it is impossible to deliberately match a firm with a company.

The appointment would be made in the name of NFRA, instead of the company even though the fees continue to be borne by the company. The composition of NFRA allows for the best mix of expertise and independence by drawing officers from All India Services who have expertise in accounting and auditing. Being a party to the selection process, the Government can take a proactive approach in preventing fraudulent accounting practices, rather than attempting damage control post facto.

The appointment now being independent, we need to fix the problem of low fees. The problem can be fixed by doing exactly that — fixing the fees. An audit is not something where the fees can differ based on performance, mostly because there's no way of measuring performance. It is sensible to remove all discretion and set fees as a fixed percentage of share capital or turnover or both.

The Financial Reporting Council, UK's audit regulator, has asked the Big 4 to hive off their audit arms into separate independent entities by 2024. Calls for 'breaking up' the Big 4 are growing across the world. This would be considered as draconian by many but more importantly, it would not even solve the problem of economic dependence on the management for appointments. It would merely prevent auditees 'rewarding' compliant auditors with lucrative assignments. Asking small and medium firms to separate their audit wings would be extremely challenging and further reduce competition in most cases. Instead, there can be a complete ban on provision of any non-audit service by an audit firm or its network to an auditee or its related entities. This prohibition can be applied consistently across firms. The fixed fee described earlier would remove the need for cross-subsidising audit assignments with non-audit assignments.

The over-dependence on Big 4 was also laid bare after the IL&FS fiasco. Taking action was difficult because too many listed companies were being audited by the accused firms. Being 'too big to fail' should never be allowed to become a hurdle against enforcing the law.

The proposed system would give a wider set of firms the chance to undertake large audits and build capacity. The system would treat firms with similar characteristics equally. The Big 4 will continue to get most large audits, given their size and experience but other large firms too well get a fair chance. Moreover, the Big 4 will not compete amongst themselves for getting business and can freely displease the management of any company without adverse ramifications. The spread of audits to a wider base of firms will create a ready supply of sufficiently experienced firms capable of undertaking audits of any size. Regulators would get the elbow room to freely take action against any errant firm without affecting the ability of companies to get suitably qualified auditors.

This novel system of appointing auditors and determining fees could transform the auditing profession into one that is genuinely independent and truly fulfils the intended objectives of the audit.

The writer is a Chartered Accountant and Company Secretary with expertise in corporate affairs and taxation, currently working at ITC Limited. Views expressed are personal