What stops Auditors being Independent?
Published: Dec 14, 2018
INVESTORS who invest their hard earned money in any company, to a very great extent, depend on company disclosures, to make investment decisions. The irony is that thousands of investors who are actual owners of a company are actually not aware about the true financial position of company.
Even the outside stakeholders like creditors, employees and customers depend on company disclosures and press releases to get information about company. On the other hand, those who are part of the decision-making team or part of management team of company have informational advantage and may act opportunistically. This problem arises due to "agency problems" inherent in the corporate structure itself. There is separation of ownership and control in the corporate structure.
In order to mitigate and resolve this problem corporate law provides for compulsory audit of companies by professionals called Auditors. The auditors are experts in their field and professionals who ought to exercise good faith and best judgment in making a corporate decision. They act as doctors who check the financial health of company and provide an independent check on the information provided to them by company. The Auditors are supposed to give true and correct picture of financial condition of company and should highlight any fraud and manipulation in accounts done by internal team of company. Stakeholders heavily rely on "Auditors Report and certificates" to make decision.
If we go back in history, early origin of the audit profession is traced from medieval Europe. Auditor's help used to be taken by guilds and joint stock companies from the thirteenth to the seventeenth century. With the development of limited liability companies concept globally, in nineteenth century England and America also created a demand for professional accountants and auditors. Gradually the audit was made compulsory for certain legal entities. The laws were framed for restricting entry of accountants through examinations and by establishing standards of conduct. In India also "The Chartered Accountants Act, 1949" was enacted to regulate the profession of Chartered Accountants.
With passage of time, considering the various scams and actual working behaviors of auditors, lacuna and short falls of the Chartered Accountants Act, 1949 and its failure in regulating and controlling the auditors came into picture. Although with the enactment of the Companies Act, 2013, some of the issues are addressed but some are still left.
Issues with Auditors:
1. Although the primary role of auditors is to resolve agency problems, their appointment leads to a new set of agency problems. It is true that an auditor is appointed by the shareholder, however, in practice the management plays a critical role in recommending who should be appointed as auditors. The auditors continued engagement in company depends on the mercy of CEOs and CFOs of the auditee company. Hence Auditors hesitate to highlight flaw in their work.
2. The auditee companies can engage the audit firm for doing additional non-audit consulting services. Their engagement for these additional works again depends on decision of company's management. Risk of losing fees for additional non-audit services and long-term audit engagement act as bar for auditors to act independently.
3. It has been observed that various firms work under a common 'network'. Network here means the existence of group of firms which have common ownership, control of management, use common brand-name and/or professional resources. There are thousands of examples where firms belonging to one network are found providing audit as well as non-audit services to the same client or its holding or subsidiaries in India or even outside India. This kind of working pattern of professional firms creates hurdles for Independence in work.
4. Another serious issue with audit profession is lack of competition in the relevant service market. The whole market is captured and dominated by a few market players. Consumers of audit services barely exercise choice actively. There always exists a risk of implicit collusions. There also exists issue of reputation depleting behavior by some audit firms.
5. In today's era, considering the working pattern of audit firms, it has become extremely important to regulate the market for audit services. The regulation should be such that it targets the agency problems emanating due to the inherent nature of the auditors' role and the resulting moral hazard problems.
Possible tools to resolve the issues:
1. Law already provides specific qualification for a person to act as statutory auditor. The law can now be amended to provide for disqualification of persons from acting as auditor on grounds of conflict of interest. A policy can be formulated for preventing auditors from providing certain non-audit services to audit clients.
2. Law can be amended to impose various disclosure obligations on auditors. The format of disclosures should be such that they can reveal the conflict of interest of auditors, sources of funds received and methodology behind their recommendations.
3. At present, audit related decisions are generally taken by the top management of a company. New rules can be framed to give this power in the hands of shareholders or creditors. The role of non-executive directors can be increased further in relation to audit decisions.
4. The law can be amended in such a way that auditors become more accountable to the shareholders and other stakeholders of auditee company.
5. The law can lay down the method of computing auditors fee and can give limit for maximum auditor's fees. In this way it can restrict the maximum fees earned by an auditor from an audit client to ensure that no one audit client is more important to the auditor than others.
6. It is essential to increase the liability risk of auditors, overand above their reputation risk. The law can increase the litigation risk that auditors would face for negligence. Criminal liability can be increased for auditors to give false statements in audit reports.
7. Once National Financial Reporting Authority (NFRA) becomes fully operational, it would be adequately equipped to handle the challenges in relation to auditors, audit firms and networks operating in India.
It is very important to create a business-friendly environment for corporates as well as professionals in India. It is equally important that Indian laws keep pace with changing market dynamics.Laws must be rationalized to promote Indian firms to offer high quality professional services at par with international standards.
(The views expressed are strictly personal.)
