Independence key to unbiased audit

ACCOUNTANCY

Any system of corporate governance must monitor the functioning of the executive management""both actively through the board of directors and passively through the market for corporate control. The effectiveness of passive monitoring in turn depends on the quality of corporate financial reports.

Corporate financial reports that have been prepared and presented using the appropriate accounting principles and methods help analysts to value the company accurately. If the company is found to be performing below potential, institutional investors begin to sell off its shares. Retail investors take the signal and sell their shares too. This threat of losing control motivates the incumbent management to improve the performance of the company. Moreover, transparency in corporate financial reporting enforces accountability and thus improves corporate governance.

It is the auditor of a company who provides reasonable assurance to the users of financial statements that those statements provide true and fair view of the financial position and operating performance of the company. Users of financial statements rely on the assertion of auditors because the auditing profession establishes and continually updates the 'body of knowledge', establishes the code of ethics that protects the independence of auditors to enable them to formulate unbiased judgement and disciplines members who are found guilty of professional misconduct.

In spite of best efforts by the profession to maintain credibility of the profession, the independence of auditors has been questioned from time to time. For example, many users of financial statements believe the auditor's assertion that the financial statements give a true and fair view, while in reality the auditor's assertion can only be a reasonable assurance.

The Enron debacle and other accounting frauds unearthed in the US brought about a renewed evaluation of auditor independence and institutional changes to strengthen it further.

Auditor independence assumes greater importance with the focus on 'principle based accounting standards'. Principle-based accounting standards provide greater flexibility to companies to formulate accounting policy than rule-based accounting standards. Therefore, in the days to come, in almost all situations, managers of companies will be required to apply judgement in formulating accounting policy. Moreover, accounting approach is moving from transaction-based accounting to event based accounting.

Accounting for impairment, asset retirement obligations, employee benefits under 'defined benefit schemes' and fair value accounting for investments are examples of event-based accounting. Event-based accounting requires managers to form a view on various factors outside their control and to estimate the value of assets and liabilities based on their own perspective of the situation.

The manager's judgement in such cases should be backed by verifiable evidence. Only the auditor is in a position to make sure of this. Investors and other stakeholders depend on his/her competence, diligence and independence. Therefore, there is a need to strengthen rules and regulations to protect audit objectivity.

Auditor independence is often referred to as the cornerstone of the profession. It is the foundation of the public trust necessary for the auditor's work to have any utility. Auditor independence 'in appearance' may not be the same as auditor independence 'in fact'. Independence 'in fact' is a 'state of mind'. Users of financial statements cannot assess actual auditor objectivity accurately. They can only evaluate the appearance of auditor objectivity.

The credibility of the auditing profession depends on the independence 'in appearance', that is the audit independence as perceived by users of financial statements. The credibility of the profession gets eroded as soon as users perceive auditors as lacking independence even though the auditor's opinion may actually be unbiased. The credibility of the profession in US eroded significantly after Enron debacle because the auditors, who earned large amounts by providing 'non-audited services' to the same firms that they audited, appeared to lack independence. Regulators formulate rules and the auditing profession establishes its own ethical code to protect auditor independence both 'in fact' and 'in appearance'.

The Indian Companies Act endeavours to protect audit independence by prescribing stringent rules about qualification of statutory auditors, the appointment and termination of statutory auditors and the rights and duties of auditors.

Further, the ethics code adopted by the Institute of Chartered Accountants of India (ICAI) provides 'dos' and 'don'ts' to protect independence. For example, this code of ethics prohibits auditors from providing certain non-audit services like book keeping and internal audit to avoid conflict of interest. Moreover, the ICAI has imposed a ceiling on fees for 'non-audit services' for auditors of public sector undertakings, government companies, listed companies and other public companies having turnover of Rs 50 crore or more. Such fees should not exceed the audit fees.

In the year 2003 the SEC introduced partner rotation. The lead and concurring partner must rotate every five years and be subject to a five-year 'time out' (cooling period) period after rotation. Additionally, certain other significant audit partners are subject to a seven-year rotation requirement with two-year time out period. Revised code of ethics for professional accountants issued by International Federation of Accountants in the year 2005 also requires rotation of audit partners.

The lead partner assumes overall responsibility for establishing the scope of the audit and is involved, in some capacity, in all significant accounting, auditing and reporting decisions.

The concurring partner reviews the audit as part of quality assurance initiative. Rotation of lead and concurring partners does not protect independence. However, rotating the lead and concurrent partner every five years would likely result in the new lead partner reassessing the scope of the work performed, thereby providing a fresh look to the audit approach.

However, this may result in loss of industry knowledge and thereby might affect the quality of audit. In India, the issue is still being debated, though a resolution is expected soon.

Recently, India has taken two important steps to strengthen the credibility of the auditing profession. The Chartered Accountants Act (CA Act) has been amended to strengthen the disciplinary mechanism. This is in response to the criticism that weak disciplinary mechanism has adversely affected the quality of audit. The second is the inclusion of a provision in the CA Act for setting up of the Quality Review Board.

The Board will have a chairman and ten members: five nominated by the Council of the ICAI and five nominated by the Central government. Both these will improve the audit quality and auditor independence in appearance and to an extent will also improve independence 'in fact'.

In India, the auditor has to take care to protect independence. The corporate sector is dominated by family businesses. The accountant and the auditor is treated as the 'friend, philosopher and guide' to the promoter-manager of the company. Auditor is an economic man and also has emotions.

Therefore, it is natural that she has temptation to protect her income by strengthening the relationship with the head of the family. It is also difficult for her to avoid emotional bonding with the family developed over long years. Therefore, the onus of avoiding impairment of objectivity lies on each and every auditor.

Regulators of the profession can form rules but cannot enforce them in spirit without the voluntary participation of the members themselves.