Institutional EYE

Commentary on Corporate Governance Issues

Auditing the Auditors: Audit Quality Indicators

With regulations and financial reporting standards set to change the audit landscape in India, audit committees must evaluate their existing auditors for their audit quality and independence, and establish criteria for selecting new auditors. To assist audit committees with this change, IiAS has drafted a list of ‘Audit Quality Indicators’ which may be used as a guiding reference to evaluate and select auditors.

Audit quality is difficult to assess in its absolute terms, but there are indicators that can reduce the subjectivity involved in evaluating audit quality. AQIs are a set of qualitative and quantitative parameters to provide a basis for comparison across different audits and audit firms. AQIs can be defined at both engagement level (indicators related to the specific audit engagement) and audit firm level (indicators to gauge the audit firm’s overall focus on quality). Globally, several initiatives have been taken to outline such measures.

IiAS AQI Framework

Workforce metrics: These set of indicators enable the audit committee to judge the knowledge and experience levels of the audit firm personnel.

Training: These metrics can be used to check the efforts undertaken by the audit firm towards skill-development and training of its audit team.

Quality: These indicators highlight the quality of audit process and instances of audit deficiencies.

Trends in audit metrics: These metrics may help the audit committee understand if fees and time involvement have grown in proportion to the complexity and volume of audit work.

Legal: These indicators highlight the instances of litigation and penalties imposed by regulatory bodies on the audit firm.

Independence: These indicators can be used to evaluate the independence of the audit team and steps taken by the audit firm in ensuring that the independence policy is not violated.

Technology: These metrics indicate how well the audit firm understands the technology being used by the audit client, and leverages technology and analytics in audit execution.

The detailed IiAS AQI framework can be found in our report

The audit committee has a multi-faceted role - a key responsibility is that of auditor selection and evaluation. Two significant changes have made these responsibilities more crucial than ever:

  • The Companies Act, 2013 has made it mandatory for the companies to rotate their statutory audit firms after a maximum of two terms of five years each, before 1 April 2017. 46 of the S&P BSE 100 index companies will likely appoint new auditors in their 2017 AGMs.

  • India is in the process of converging towards globally uniform financial reporting standards by the implementation of the Indian Accounting Standards (‘Ind-AS’). The transition is not just a change in accounting framework, but will have an impact on almost all business functions of the company. The internal control framework will need a complete overhaul and the audit function needs to play a pivotal role in testing them and reporting any deficiencies to stakeholders.

An AQI framework will help the committee in laying down objective criteria for evaluating audit firms and benchmark audit firms against one another.

Being transparent about audit quality is in the best interest of all stakeholders. It provides confidence to the capital markets in the sanctity of financial numbers reported by companies. AQIs will allow audit firms to provide evidence of their expertise and quality in a tangible, quantitative form. Such a framework will also help audit firms push themselves to a higher standard and foster healthy competition between audit firms on their quality metrics.

Audit committees can use the framework provided by IiAS as a starting point; and finalize a set of AQIs by incorporating industry-specific and company-specific nuances. As AQIs are a relatively new concept, there are no established benchmarks to evaluate audit quality. However, we believe that the audit committee must define what works for them, based on their own criteria and filters. Over time, as more audit firms report AQIs on a regular basis, benchmarks for quality will be automatically set.

AQIs can supplement the government’s effort of monitoring and improving the audit quality in India. The Quality Review Board (QRB), established by Parliament under The Chartered Accountants Act 1949, is a 10-member panel (50% of whom are members of The Institute of Chartered Accountants of India – ICAI). Its Report on Audit Quality Review 2015-16 indicates that the QRB has conducted 454 reviews since August 2012, of which 257 reviews have been finalized. As a result of finalizing 257 reviews, in 136 cases (53%), the QRB issued advisories to audit firms “for improvement in quality” , and referred 6 cases to ICAI for “initiating disciplinary proceedings”.

With companies implementing AQIs in selecting or retaining audit firms, the agenda to improve audit quality will spread faster – the need to compete will ensure audit firms undertake self-improvement measures. This will benefit not just companies, but the audit industry. Over time, it may well put to rest the oft-repeated lament from corporate India on the paucity of good quality, experienced audit firms.

For entire report click here

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