I intended to sign off the year 2014 on a much happier note, putting before the readers the thoughts of a resurgent India, expectations of economic reform and the prospects of a prosperous year to come. However, two events compelled me write on a much more serious issue. The first was an article on “Accounting scandals” which appeared in the Economist on 13th December, and the second was the report of the CAG on third-party reporting tabled before the Parliament on 19th December.
The Economist article describes an erroneous decision made by the investment guru Warren Buffett, attributed to a grave accounting error which was not noticed by the auditors. The article describes a large number of business failures, resulting in huge losses to investors which could have been avoided if there had been proper reporting by auditors. The article, a balanced one, states that the auditors, at the very least, failed to raise an alarm.
Back home, the CAG report on tax audit reports is far more scathing. According to the report, the errors by the tax auditors, resulted in a short levy of taxes to the extent of Rs. 2,813 crore.The CAG audit report lists specific areas where tax auditors have failed to perform their duties. The report recommends action against errant auditors. While it is likely that some of the views expressed by the auditor may be on account of a genuine difference in interpretation, or some may be bona fide errors, it is improbable that this is the case in respect of all shortcomings that have been reported.This may occur on account of the tax auditor not having the requisite skill set. While I do not wish to engage self-flagellation, it is true that some of our professional colleagues have not realised that if one is to deliver quality service, knowledge needs to be continuously updated. One cannot afford to rest content with what one has learnt in the past. There is one issue that also needs attention. The tax audit report at the stage that it was introduced was expected to assist the assessing authorities in framing assessments. From an assurance on correctness of data form 3CD now requires expression of opinion on a number of issues some of them complex. Is this what is expected of the auditor? Possibly the regulator that is the ICAI and the concerned authorities need to revisit some aspects in regard to the scope of the report.
As regards audit which gives an assurance in regard to financial statements, over the last few years there has been a continuous erosion of the confidence which investors, regulators and the general public reposed in the ability and integrity of auditors. One talks of the “expectation gap” on a number of occasions, but it has widened rather than narrowed.
The real scope of audit, and the limitations in which an auditor functions have not been appreciated by the users of financial statements, and the profession has failed to educate them. Nearly a century ago, a British judge had said that an auditor is a “watchdog and not a bloodhound”. The auditing profession has used that assertion as a shield, while not realising that a domesticated watchdog may gradually forget his true role. What is expected by the public is a guarantee that the accounting statements are true and correct, while what the auditors express is an opinion on the accounts with significant caveats which are not understood by the reader at all. While one fully understands that it is virtually impossible to give a guarantee of accuracy of accounts, given the gamut of complex accounting rules and standards it is extremely difficult for the user to understand the true import of the “opinion” expressed. This expectation gap must be bridged urgently if the auditing profession intends to retain the respect and confidence of the users of financial statements.
The second aspect which is a cause for concern is the conflict of interest. The users or beneficiaries of the services of the auditor do not pay for the same. In practice, investors have very little say in the appointment of an auditor or in determining his compensation. The purchasers of his services, do so only because they are required to. To put it bluntly, an auditor is appointed not because the management believes that he will add value but because there is a statutory mandate. Therefore, in theory, an auditor protects the interests of shareholders and regulators, but in practice, his concern is that if he barks too loudly he will be driven out. The Companies Act, 2013 seeks to address this problem by providing for rotation of audits. To what extent this will be successful remains to be seen.
Another problem is that the users of auditing service have a serious lack of choice. The Economist article points out that more than 90% of the top companies are audited by the big four. Managements tend to choose from among these auditors believing that if any other service provider is used, it may not be acceptable to investors. With large companies having business interests across the globe, the tendency is to deal with a firm who has presence in all countries. While one can have no quarrel with the prosperity of our professional brothers, companies need to realise that there is local talent with the same quality, if not better, in the auditing profession in many countries. If there is serious competition, auditing firms may be on their toes to ensure a value add, rather than ensuring compliance with the letter of the regulation.
In this scenario where the profession is being blamed, what is the solution? One obvious answer is the deterrent legal action against the apparent wrong doers. The Economist article states that given the judicial system and the complex accounting rules auditors have been able to ward off compensation claims with minimal payouts. Other penal actions have also not been very successful.
The only lasting solution is regulation. While there are no immediate answers, it is necessary to ensure greater healthy competition among service providers. The profession is already looking at consolidation in mid-size firms and that process needs to accelerate. The “audit committees” of companies need to be given more teeth and need to be manned by independent professionals. Another suggested remedy is scrapping of the statutory requirement for audit altogether. The supporters of this theory say that this will ensure that service providers pay more attention to what value addition they can provide and what users of service really want.
The Economist article contains a novel solution by Joshua Ronen, a professor at a New York university. He propounds a concept of”financial statements insurance”. Insurance firms will provide coverage to protect shareholders from accounting errors and will hire auditors to assess the odds of a misstatement.
This being the last editorial for the year, let me not end on a gloomy note. Our profession, hitherto dominated by the male species has seen an increasing number of young lady entrants. Let us then welcome the young ladies to the profession. May their tribe increase!
Wishing all readers a very happy and prosperous 2015,
