Why the Big 4 continue to gain in audit industry

Restrictive provisions in the Companies Act might prove to be a windfall for the Big 4 auditors in India

Efficiency of any audit market is broadly measured by audit quality. Audit quality, in turn, depends on the ability to identify misreporting and errors in financial statements and willingness to report such errors and/or misstatements. While the first factor relies on the skill and competence of auditors, the second one depends on the independence of auditors. The evolution of the global audit market over the past three decades showed the concentration of the industry — from Big 8 to Big 4 auditors.

The audit market in India is no different and is characterised by three features — dominance of Big 4 auditors, increasing share of non-audit fee and advocacy for joint audit. Within the Nifty 500 subset, the dominance of Big 4 auditors was significant: They handled a total of 234 audits (46 per cent) during 2015-16. The average audit fee earned by the Big 4 auditors during 2015-16 was Rs 1,197 million — 90 times more than the overall average. About a quarter of the fees earned by Big 4 auditors came from non-audit services. Other services for non-Big 4 auditors constitute 10 per cent of the total fees. Therefore, non-Big 4 auditors were more dependent on audit fees. A natural concern would be the consequence of such an oligopolistic audit market on audit quality.

The Companies Act, 2013, seeks to address the audit quality issue from two angles — auditor rotations and prohibition of certain non-audit services to audit clients. Rotation of auditors was made mandatory for listed and many unlisted companies, effective from April 2017, in situations where an auditor has served in that capacity with a particular auditee for 10 or more consecutive years. There is also a provision for a cooling period of five years for the audit firm. One more important provision in this respect is about the rotation of an audit partner. The law states that no audit firm having a common partner(s) with the other audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of five years. It implies that if a signing partner of an outgoing audit firm (due to rotation) joins another audit firm, the latter would also be ineligible for appointment as auditor of the same audit client in the immediate subsequent year. Consider an example: If X, signing partner of audit firm ABC (which has just completed 10 consecutive years of audit of a client MNO) joins a rival audit firm, PQR, the latter audit firm (PQR) will not be allowed to conduct audit of MNO for at least a year.  However, if MNO approaches PQR after a gap of one year since ABC audited the company, PQR would have no restriction in accepting the audit client. Therefore, Indian corporate law does not specifically require audit partner rotation.

Illustration: Binay Sinha

 

Recent data on the Indian audit market show that auditor rotation did not adversely affect the volume of business of Big 4 multinational audit firms. For example, the top two of the Big 4 auditors in India (Deloitte and EY) have bagged enough new auditees from smaller auditors to compensate for the number of clients they lost due to mandatory audit rotation. It has also been observed that large Indian companies chose to swap auditors or replace an Indian auditor with one of the multinational audit firms. Therefore, the audit swap among Big 4 firms also denied any additional business opportunities to local and smaller audit firms.

To ensure the independence of auditors, another restrictive provision in the Companies Act relates to rendering of non-audit services. Services outside the ambit of a statutory auditor include internal audit, bookkeeping, investment advisory services, investment banking services and management services. The restriction is much wider — it includes not only the audit client but also its holding or subsidiary companies. The term “management service” is a little vague and nowhere defined in the Act. Therefore, it is not clear which non-audit services, other than taxation services, might be assigned to an auditor.  Will this restriction improve auditors’ independence? The answer is not straightforward. One obvious argument in favour of such a restriction is to ensure that auditors are not dependent on corporate largesse and hence can be forthright in expressing their opinion. The “resource diversion” view suggests that expanding consulting services could undermine audit quality. The argument against such restrictive provisions is equally strong. Providing consulting services may improve audit quality — consulting staff often provides the audit staff with valuable insights because they act as “domain specialists” on audit engagements.

If one considers the above two restrictive provisions — auditor rotation and prohibition of non-audit services — a natural question would be whether these provisions would have a negative effect on the overall income of the Big 4 audit firms. It is quite possible, and also perfectly legal under the new corporate law, that an audit firm retains the non-audit services of a client while relinquishing the audit services. Thus, the Big 4 audit firms would only swap their audit clients for audit services and retain non-audit services of the old clients. The restrictive provisions of the Companies Act might prove to be a windfall for the Big 4 auditors in India.

Ashok Banerjee is a professor at IIM Calcutta; Leesa Mohanty is a post-doctoral research fellow at IIM Calcutta

A version of this article appeared in Artha, an IIM Calcutta magazine