Why the UK CMA report is relevant for India

The report gives a pragmatic framework that calls for a shift if statutory audit is to survive as a private sector activity

The CMA of UK recently released its much awaited report on changes necessary in the audit profession. There is absolutely no doubt that the current audit market in most countries suffers from dated and artificial restrictions, which end up preventing the growth and development of multiple credible audit firms in the profession, in the end harming audit quality. 

An audit business is run as a partnership (or LLP) and not as a company. An amalgamation of many senior professionals who come together as co-owners (provide capital and their skills) to deliver the promise of protecting public interest and assume joint and several liabilities in the process. The model, therefore, has an infinite ability to self-finance and grow provided there is demand. 

Anything that artificially restricts the ability of a group of capable professionals getting together and competing in a profession will not serve public interest, on the contrary, it shall restrict choice for not just companies and users, but also for the practitioners themselves.

The Big4 tag, is one such artificial restriction that has become a barrier to allowing companies to choose an auditor outside those that are a part of this group, and provide a false and artificial halo of quality linked to size. Audit is perhaps the only service industry or profession where size is perceived to be synonymous with quality. Just consider are the best hospitals, the best lawyers, the best hotels also the biggest by size? Has one ever asked to be taken to a Big3 hospital or served by a Big5 lawyer or be only booked in a Big2 hotel chain? 

Just like Europe banned any restrictive covenants on auditor selection (so called Big4 only clauses), and India has also adopted a similar approach (in the case of FDI), we ought to go further. It’s an absolutely travesty how many quality audit firms have nearly gone out of business in India because investors insist on a ‘BigX’ auditor (a term that itself was not prevalent in India or relevant to this market, where we had many quality firms of our own). Remember even today over 100 Indian audit firms have connections with an overseas firm, and each of these firms is as capable as anyone else. 

The challenge is demand, not supply. If there was demand for their services, many of these 100 firms could beef up their supply by attracting partners and staff. It is a chicken and egg situation but demand will create the supply, and without these artificial barriers being removed there won’t be demand. 

The UK CMA report which recommends mandatory joint audit (MJA) between a Big4 firm and a non-Big4 firm for FTSE 350 companies is path-breaking in this respect as it addresses all these issues head on, extends accountability to audit committees, and does so in a manner that is gradual and leaves room to revert to Single Audit Firm (SAF) in a few years once this problem has been fixed.

The Report has recognised that audit is not the only business at Big4, resulting in a financial interests that may cast doubt on their objectivity as auditors, and therefore recommending split of audit and non-audit businesses. In India, the Committee of Expert set up by the MCA recognised this issue as well. The CMA has gone one step further in its recommendations of operational split in the businesses of the multi-disciplinary firms. Indian regulators ought to take note of what proportion are audit revenues to the total revenue of a firm and more particularly for an audit client. 

The report has accepted that mindset of a Big 4 while selection of auditors needs to change and therefore recommended audit committee reviews. This is a typical problem in Indian market as well. The selection of audit firms is often driven by a perception that Big 4 brings audit quality, whereas there are a number of alleged failures to counter that perception. Indian regulators hoped that mandatory audit firm rotation would bring in vibrancy and create larger audit focused firms, something that our Prime Minister publicly stated as a vision. However, one needs to evaluate if the mandatory audit firm rotation, indeed helped in that purpose and how many audits of large listed companies moved out of the Big4; and if this concentration is indeed acceptable. The CMA report clearly outlines specific steps to move away from this Big4 concentration and our regulators ought to take a cue from that.

I hope the NFRA and the MCA will take notice of this report and consider adopting a similar requirement for at least the Top 100 companies by market cap as and when they next need to change an audit firm because of 10-year mandatory firm rotation. Whilst this may seem against the interest of the Big4 firms initially, I would urge the partners in those firms to consider if they would rather have more opportunities that will make the whole profession vibrant and keep audit valuable, or continue to hope that artificial barriers remain where only four to five firms continue to serve the market, as even for these firms' audit growth has saturated as a share of their total pie (shift to more profitable ‘advisory’ businesses). 

I also urge the shareholders and audit committees of these 100 largest listed entities in India to support the creation of perhaps 10 large audit firms in India that will, in the long run, help make our capital markets more efficient and attractive, and be open to examine the possibly of MJA. 

The CMA report gives a pragmatic framework that will require a shift if statutory audit is to survive as a private sector activity. If we adopt some of these changes, and all concerned think a little beyond self-interest, audit cannot just survive but actually thrive. 

 

The author is CEO, Grant Thornton India LLP