Are auditors a soft target?

Auditing is an age-old profession. In the early stages of the English East India Company, when it was operating as a purely commercial venture, a few shareholders used to conduct audit voluntarily on behalf of the shareholders. Although auditing has changed its form over the years, the basic objective remains the same. It is to provide an assurance to shareholders, particularly, non-controlling shareholders, lenders and other creditors that financial statements provide a true and fair view. Detection of fraud is not the primary objective of an audit. That is the objective of a forensic audit. 

The auditing profession introduces stricter auditing standards frequently to earn investors’ confidence. New auditing standards, the emergence of complex business transactions, and increasing uncertainties in the business environment have made the auditor’s task challenging because audit involves judgement and developing perceptions about the impact of various transactions and events. For example, an auditor has to make a judgement, based on regulator’s guidance, on at what stage greening of a defaulter’s loan crosses the boundary of normal business practice and enters in the realm of fraud.

Until growth in the equity segment of the capital market and growth of the mutual fund industry, with the entry of private sector mutual funds in 1993, an auditor was considered to be a ‘philosopher, friend and guide’ of the management and audit was considered a ‘personalised service’. With the entry of big four international audit firms (Deloitte, E&Y, KPMG and PWC), the concept of ‘branded audit service’ came in India. Before, the enactment of the Companies Act, 2013, there was no mechanism to penalise the firm for professional negligence or other misconduct of a partner of the firm. Only the errant partners used to be penalised. This shows how deeply the perception of ‘personalised service’ was ingrained in the Indian system. 

For long, even in the changing context, the auditor failed to switch allegiance from the management to shareholders, because non-controlling shareholders, including institutional shareholders, seldom intervened in decisions regarding the appointment and remuneration of the auditor. Even today, usually, the recommendation of the board of directors regarding an auditor’s appointment gets approved in the annual general meeting. The audit committee of the board of directors is responsible for protecting the independence of the auditor and decide the auditor’s appointment. In most cases, the audit committee fails because independent directors do not act independently of the management. Management plays the key role, often tacitly, in the appointment of the auditor. 

In this situation, regulators do not find any option other than using the stick to improve audit effectiveness.  

In recent times, regulators are taking a hard look at the auditor’s role in corporate governance failures. Recently, in the case involving IL&FS Financial Services (IFIN), a subsidiary of IL&FS,  the Serious Fraud Investigation Office (SFIO) named the auditors (Deloitte, KPMG affiliate BSR & associates and A P Shah & associates) as parties, which colluded with the management to conceal information and falsify accounts. According to the charge sheet, “the auditors, despite having knowledge of funding the defaulting borrowers for principal and interest which was prejudicial to the interest of the company and its creditors besides having awareness of the impact of the same on financial statements, failed to report in the report for FY13-14 to FY17-18”. On June 10, 2019, the Ministry of Corporate Affairs moved the National Company Law Tribunal to bar the auditors of IFIN from the business for five years.

Last year, the Securities and Exchange Board of India (Sebi) banned PwC from auditing listed companies for two years over its involvement in the Satyam Computers scam. On June 3, 2019, the Reserve Bank of India banned S R Batliboi & Co, an affiliate of EY, from auditing commercial banks for a year starting April 1, 2020, citing lapses in the statutory audit. 

It will be interesting to see how the auditors of IFIN defend themselves. According to them, they applied standard audit procedures and applicable professional standards. If, they successfully defend their case, it will be established that the expectation gap (what regulators expect auditors to do and what they can actually do) is widening. 

Whipping the auditor because of its failure to meet the regulators’ and public expectations will not improve the audit quality. It will weaken the confidence of investors and creditors in the auditing profession rather than strengthening the same. Also, the profession will fail to attract talent. This will harm the profession. 

Auditors should not be used as a soft target. It will do more harm than good to investors. 
 

The writer is director, Institute of Management Technology Ghaziabad; Mail id: asish.bhattacharyya@gmail.com