Indian MCA Proposes Audit Reform to Improve Quality

To improve audit quality, increasing oversight is a far better approach than trying to increase competition by imposing regulatory limits on audit engagements.

In a market like India, where corporate governance concerns are top of mind for investors, the role of auditors in providing assurance to investors is critical.

Audit firms, however, have been facing increasing scrutiny in recent years, whether globally for their alleged deficiencies in audits of such companies as Wirecard, Carillion, or General Electric, or in India, for their role PMC Bank, Punjab National Bank, or the finance company Infrastructure Leasing & Financial Services (IL&FS).

Earlier this year, the Indian Ministry of Corporate Affairs (MCA) floated a consultation paper on audit independence and accountability, covering far-reaching reforms in the audit market, including reviewing the concentration of the Big Four in the market, auditor appointments, and joint audits. While these proposals rightly caught the attention of stakeholders and the media, the paper also contained other proposals, which if implemented, would make material improvements in audit quality.

Proposals that generated the most attention

Consider the most discussed issue in the paper, which is reducing the concentration of the Big Four firms. The paper discusses limits on several dimensions, like the number of audits per firm or auditors, or the number of partners per audit firm, and in general, how to reduce the workload of the Big Four firms.

The Big Four firms haven’t acquitted themselves well in several instances. In the case of Wirecard and the erstwhile Indian software major Satyam, they even were implicated for their failure to properly account for cash balances. This desire to look beyond them is understandable.

For a market to be perfectly competitive, however, it not only needs numerous buyers and sellers but also needs them to be well informed. In the current audit market, buyers of audit services — ultimately investors — do not have the information necessary to judge audit quality, leaving behind a market for lemons. In this scenario, increasing competition without a commensurate focus on audit quality may result in increased price competition and a possible reduction in audit quality.

The consultation paper proposes that auditor appointments could be made from a panel maintained by an independent agency and argues that the current scenario in which management decides the choice and remuneration of auditors leads to conflicts of interest. Indian listing regulations, however, already place the onus on recommending appointments and remuneration on the audit committee composed of independent directors (not management) and subject to approval by shareholders. This is as it should be. To further reduce conflicts of interest, audit committees also should have authority over their budgets and over statutory auditors. Through these protections, investors will come to trust the financial reports issued by companies. While regulators could provide additional scrutiny of audit committees, the proposal to replace their role in auditor appointments would be counterproductive and take away scarce regulatory bandwidth without improving audit quality.

The consultation paper also discusses mandatory joint audits and the so-called four-eyes principle to reinforce audit quality. Joint audits do not improve audit quality; they create competition for management and audit committee approval to the detriment of audit quality. They also reduce accountability to investors. Such audits require careful coordination, cooperation, and division of responsibility between two firms and then communication of audit information to investors. Barring such safeguards, merely getting an opinion jointly signed by two firms would not be an improvement.

Least discussed but most promising ideas

While these issues have generated the most attention, other modest proposals have the potential to improve audit quality in a meaningful way.

The proposal to enable the auditor of holding companies to comment on the working papers of subsidiary companies is a useful measure in group companies which employ different audit firms for the parent and its subsidiaries. Listing regulations already require auditors to undertake a limited review of entities which are consolidated with the listed entity. The proposal for concurrent audits of large transactions is useful and would serve as an early warning system.

But the biggest improvement in audit quality would come from the proposal for regulatory inspection of audit engagements as a means of supervision and enforcement. Regulators around the world, like the US Public Company Accounting Oversight Board, the Canadian Public Accountability Board, and the UK Financial Reporting Council employ various selection methods based on the audit firm size and risk profile of the industry and issuers. Within the selected engagements, these regulators focus their attention on the more complex, challenging, or subjective areas. The resulting public inspection reports provide investors with useful information about the extent and areas of deficiencies and incentivises audit firms to improve their processes over time.

Conclusion

The impulse for big changes and signalling intent in the face of diminishing trust is a natural reaction, but regulators could improve audit quality in a meaningful way by focusing on tighter enforcement of existing rules and providing oversight of audit committees and audit firms.

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