Auditing and public oversight

ACCOUNTANCY

As per latest reckoning nearly 150 Indian companies, audited by as many as 91 auditors, have their debt or equity listed on exchanges in Europe. Most countries in Europe, currently 27, form what is called the European Union (EU).

The EU promotes a single market among its member states through law and regulation which now, through the EU's Statutory Audit Directive (8th Directive), includes the audit profession. Once implemented by the EU member states, the 8th Directive could mean that Indian firms which audit non-EU companies listed on stock exchanges in any of the EU member states, may have to face local EU regulatory oversight.

All audit firms outside the EU, whose clients are listed on regulated exchanges in the EU (as public interest entities), may be required to register with the local audit regulator in the EU member state where the client's shares are listed.

If the firm has to register, the relevant regulators will then be required to oversee these firms and subject them to the local Quality Control and systems of investigation and penalties, in the relevant member states where the clients are listed.

A fundamental consideration for deciding whether registration is required is the evaluation of the Public Oversight System (POS) in the audit firm's country of origin.

One of the requirements that will enable the Indian POS to achieve "equivalence" and reciprocity will be the execution of its governance by non-practitioners.

At the most, a minority of practitioners can be involved in the governance of the POS. These may be specialists who have never been linked with the audit profession or former practitioners. By definition, a non-practitioner should not have been associated with an audit firm or carried out audits for at least three years before his involvement with the Oversight system.

In contrast, in India, the Institute of Chartered Accountants of India (ICAI) has historically had an overwhelming majority of practitioners on its governing body. This single fact may become the highest hurdle for evaluating the adequacy of Oversight on Auditors by external regulators.

This independent POS, as per the 8th Directive, should have the ultimate responsibility for the oversight of approval and registration of statutory auditors and audit firms; adoption of standards of professional ethics; internal quality control of audit firms and auditing; continuing education; quality assurance; investigation and disciplinary systems. Nearly all of these today are exclusively the prerogative of the ICAI. Does this indicate a major shift in the role and function of ICAI, a few years down the line?

In addition to evaluating the effectiveness of the POS, the local EU regulators in the relevant member states will separately evaluate the effectiveness of the quality assurance system (Peer Review) in the country.

While we would struggle to satisfy a number of the above considerations, on the last point above, the ICAI has very consciously and by public announcement totally de-linked the Peer Review system from any disciplinary consequences. Therefore, for both Independent Oversight and the matter of "consequence management", the quality assurance system in the country would have to be restructured to meet EU Standards.

The 8th Directive also requires the presence of an effective system of investigation and penalties, as well as providing for effective proportionate and dissuasive penalties on audit firms for inadequate execution.

Last but not the least, the EU requires audit firms, which have clients listed on an EU-regulated exchange, to produce an annual Transparency Report. These reports have to be published on the auditors' respective websites and include information about the firm such as a description of its legal structure; ownership; network, governance structure, internal Quality Control system and a declaration by the management on the effectiveness of its quality control processes.

Auditors are required to display information that indicates when the firm was last subject to an external quality review; a list of all public interested entities audited by the firm; a statement of the firm's independence practice and confirmation of internal review of independence compliance and a statement of the Continuing Professional Education Policy followed by the firm.

The 8th Directive has to be implemented by all EU member states by June 2008. The countdown has already begun,

The author is director, Ernst & Young India Pvt Ltd. Views expressed are his own.