In recent times, including an article* by S Murlidharan in Business Standard, a case has sometimes been made for audits of private companies by auditors appointed by a Central authority, such as the Comptroller and Auditor General (CAG), in a manner that would parallel the appointment of statutory auditors of public sector undertakings (PSUs). Such an extreme step is not warranted; there are ways in which private sector audits would be more effective.
The system of appointment of statutory auditors by shareholders has functioned effectively for over 60 years since the Chartered Accountants Act was passed in 1949, and for 56 years since the Companies Act, 1956 came into effect. Apart from Satyam, there have not been many significant audit failures. A few audit failures cannot be construed to imply that the system itself is faulty and requires an overhaul.
The role of CAG is to ensure that public resources (particularly resources raised from the public in the form of taxes) are used for purposes that would further public welfare, and not be misappropriated. The potential for misappropriation is much higher in the public sector because bureaucrats managing PSUs can, in practice, be manipulated by politicians (who more often than not have their own agenda). There could also be instances of collusion between bureaucrats and politicians to the detriment of public interest.
In such a situation, the requirement for an independent and sufficiently empowered CAG is absolutely critical. Such compulsions do not exist in the private sector, since the management is directly answerable to shareholders, and indirectly to other stakeholders (such as lenders and income tax authorities). Controls are also exercised by the Securities and Exchange Board of India for listed companies. Moreover, putting the onus of private sector audits on CAG would divert the auditor’s attention from auditing the public sector which, after all, is the raison d'etre of CAG.
It is also argued that auditors of companies in the private sector focus excessively on accounting matters without considering matters of propriety. This argument ignores the various tenets of the Companies (Auditors Report) Order, 2003. These require auditors to comment on various matters of propriety, such as whether the company has an internal control commensurate with its size and nature of business, the efficacy of the internal audit system, whether loans and transactions with companies in which directors have an interest are made on reasonable terms, whether the company has defaulted in repayment of dues to banks and financial institutions, and whether frauds on or by the company have taken place.
It is contended that auditors of private sector companies are not independent because they are appointed by the shareholders. Reference, in this regard, can be made to the specific powers and duties of auditors under the Companies Act, 1956 for which they are accountable under the law and to the fact that chartered accountants are also governed by a code of conduct under the Chartered Accountants Act, 1949. Over 50 years, the number of audit failures in India would perhaps not exceed even one per cent of the total number of audits performed, which indicates that the system has performed reasonably well.
The legal framework needs to be made more conducive, so that auditors can report wrongdoings of companies without being victimised. One of the possible steps that might be considered is that it should not be possible to remove auditors for a period of time once the auditors’ report has been qualified or once the auditors have identified improprieties in the company.
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While the new Companies Bill, 2012 intends to introduce mandatory rotation, more detailed reporting responsibilities and criminal liabilities for auditors, auditors receive little support from the legal framework in respect of their audit fees. A basic premise that requires to be accepted is that audit quality comes at a premium. A successful audit of a large manufacturing or service company requires a large audit team comprising suitably qualified and experienced personnel who would have to be paid competitive remuneration so as to attract the best of talent. Mandatory rotation of auditors could lead to a downward spiral in audit fees charged by competing audit firms, which would adversely impact audit quality.
Another idea that requires consideration is an oversight mechanism to monitor the quality of audits performed in India on the lines of the Public Company Accounting Oversight Board in the US. If such an oversight board begins to examine the quality of audits performed on listed and other large private sector companies in India, it would automatically improve the quality of such audits by pointing out the shortcomings in audit processes as well as ensuring that such lacunae are duly addressed.
At the end of the day, in a democratic country like India that believes in the virtues of free enterprise, it would be counter-productive if audits took on the guise of investigations. Statutory auditors also have a role to advise management regarding the quality of their internal controls and processes and efficient utilisation of resources. Such suggestions add value to the audit process and enhance the auditor-auditee relationship.
An unduly aggressive approach on the part of auditors can lead to acrimonious relations between the auditor and the management. It can also have a negative impact on the innovative risk-taking spirit of entrepreneurs, which lies at the heart of free enterprise. An excessively conservative approach towards risk-taking, innovation and decision-making in the private sector would be detrimental to economic progress. While such conservatism (which is at least partially attributable to the rigorous audits performed by CAG) is perhaps necessary in the public sector; it is certainly not advisable in the private sector.
The solution is to improve and strengthen the existing statutory audit framework in the private sector rather than pursuing impractical alternatives such as audits by CAG.
*“Need for public sector audit in listed private companies”, November 5, 2012
The author is a chartered accountant