Institutional EYE

Commentary on Corporate Governance Issues

Can a broken songbird sing?

June 21, 2019

 

 

Never waste a good crisis. The audit industry needs to be fixed and recent developments provide the perfect trigger to rethink its future. 

 

It is a scary time for the big four auditors in India. Their worry is not so much the business model of providing audit and a myriad of non-audit services; that, if regulators demand, they will reluctantly tweak. It is the audit quality and the numbers they are printing, that shareholders, lenders and regulators are now questioning.

 

Look around. The Securities and Exchange Board of India (SEBI) banned PwC in 2018 from auditing listed companies for two years for its involvement in Satyam Computers Services Limited. Last month, the Reserve Bank of India barred SR Batliboi & Company LLP, an affiliate of EY, from carrying out statutory audit assignments of commercial banks for one year. The Serious Fraud Investigation Office has charged Deloitte Haskins & Sells LLP and BSR and Associates LLP (part of the KPMG network), for their failure in not disclosing the true financial health of IL&FS Financial Services Limited and the Ministry of Corporate Affairs (MCA) looks at banning them from undertaking audits for a period of five years.

 

How have things come to such a pass?  Clearly, it’s been a while in the making.

 

For one, the change in audit rules. From principles of prudence and conservatism, which enabled auditors to certify that the numbers are ‘true and fair,’ there is a shift to ‘fair value’ which despite its theoretical underpinnings, has led to Sharon Bowles, a former chair of European Parliament  economic and monetary affairs committee, to describe it as the ‘un-anchoring of auditing from verifiable facts’. My own experience while handling an IPO of a technology company in the late 1990’s was the trepidation of its CFO when asked to prepare US GAAP accounts, giving way to high-fives, when he realized that management assumptions could be far more generous than what his local auditors allowed. Indian audit rules are far more aligned with global rules today, than any time before.

 

And rather than being ‘useful to users’ fair value accounting has at often times left investors and various other stakeholders, at the mercy of the auditors – who have just ticked the box, rather than exercise their judgement: in Charlie Mungers words ‘violated the most elemental principles of common sense.’ Auditors defend themselves saying that it is difficult to over-ride management when it comes to exercising judgement on business issues; recent events suggest they need to show spine and push-back, as PwC has recently done.

 

Some argue that audit failure to provide robust results is a consequence of their cosying up to firms they audit, in the hope of non-audit related business. Today the big four companies audit 60% of the NIFTY 500 firms, thankfully not as dominant as in the UK (97% of the FTSE350) or US (99% of the S&P500).  Deloitte’s global revenues in 2018 were US$43.2bn, followed by PwC (US$41.3 bn.), EY (US$34.8) and KPMG (US$29.9bn). Between themselves they employ 1,005,753 people. Just to put their revenues in context, Morgan Stanley’s global revenues for 2018 were at US$37.9 bn and those of Goldman Sachs, US$36.6 bn. The UK’s Competition and Market Authority (CMA), in its recent review of the audit industry, found that each of the Big Four generates at least three quarters of its revenue from non-audit services.

 

What then needs to be done? Should they be splintered into smaller ‘all service’ firms, should they be vertically split into audit only  and non-audited firms or should there be a hefty fine for each transgression and they be allowed to continue, if the market believes they are now too important to do without? If the market believes moving forward without them is too disruptive, this is the practical and most acceptable - but short-term solution.

 

As the big four audit firms brace themselves for a shakedown, it is not clear who the winners will be. The domestic firms, for the most, have merged with the big four - their skills and importantly, their roster of clients, was far too attractive to the majors to leave untouched. Can the handful of remaining domestic firms benefit from this? It is not obvious if they now “have-it” to compete; partly this is because the companies are much larger, more global and more complex, which puts the smaller firms are a disadvantage vi-a-vis the big boys.  And in part, because investors push firms to embrace the Big Four. The current crisis provides them with an opportunity, and it will be a shame if they do not take advantage that this environment provides. No one will argue that we don’t need more choice. Indeed, the more daring amongst us will argue voting out the big four (- assuming the regulators don’t ban them) and bring in the smaller firms arguing that the big four have not provided the assurance their brands promised. HDFC Bank recently appointed MSKA & Associates, a firm outside of the big four. Its own credibility will compensate for that of its auditors. This could be the starting point of rejuvenating the industry, with the better governed firms moving beyond the big four.

 

In India, a Committee of Experts in its report to the Ministry of Corporate Affairs focussed on the ownership structure, found it in compliance with Indian law, and believed that the National Financial Reporting Authority will solve the various intractable issues that face the industry today. In sharp contrast the CMA in its report has suggested breaking-up the big four to increase choice and introducing joint audits, which will enable smaller firms to upskill themselves – the two issues which we In India grapple with  today. Agreed that just having more firms will not solve by itself solve the quality problem. So, to this let me add a third, tight oversight over audits and auditors. The recently set up National Financial Reporting Authority (NFRA) has its work cut out.

 

Fourth, a contentious suggestion for the various stakeholders to consider, but entirely dependent on data. Should audit fees go up? Unless audit fees move up such that the auditor feels rewarded for the time, quality and even the risk of auditing, we will continue to see the big four chasing non-audit revenues and the smaller firms focusing on tax and loan syndication. This assumes that the audit firms are honest in reporting the audit fees they earn, and do not show a lower number by filtering-out certain heads. Increased fees can be double-edged as it may make firms more malleable. The converse is audit will not be a focus and cannot be desirable.

 

Change will take time and most suggestion need wider debate. Meanwhile I advocate institutional investors and even audit committees, get involved in the policy debates around audit standards. Albeit an arcane subject, the ramifications are too far reaching and too long term, to ignore.  Quicker still, investors should be more questioning of audit reports and auditors should open-up to talking to shareholder who vote their appointment, rather than cite client confidentiality.

 

The chartered accountants, possibly envious of doctors driving with a sticker of either a red-plus sign or the Rod of Asclepius on their windshield, decided to march in step with them, and put a ‘CA’ sticker on their windshield. As an aside, my colleague Hetal Dalal often asks, what is the relative probability of someone stopping a doctor on the roadside for a medical emergency versus flagging down a bean counter to give a tax opinion. Coming back, having embraced and made their own a car-sticker, auditors should now go the full distance, by paraphrasing and embracing a line about physicians from the bible. Let me help with it. Auditor, heal thyself.

 

A modified version of this article by Amit Tandon, appeared in Business Standard on 21 June 2019 under the headline ‘Can a broken songbird sing?’

 

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