Challenges in enhancing audit quality

The most discussed topic today in the audit profession is audit quality. The Ministry of Corporate Affairs (MCA) recently published a consultation paper, the success of which is predicated on a strong framework, consistent application, and engagement. I have examined certain key concepts that impact audit quality, the central theme of the MCA paper.

Audit reporting on subsidiaries’ accounts

To avoid negative consequences of an auditor not having visibility over a corporate group, the paper requires mandatory comment by the parent's auditor on its subsidiaries' accounts. This cannot be effectively achieved by reviewing the subsidiary auditors' work and will be inefficient to have the parent auditor re-perform the audit of the subsidiary.

One solution is to replace the current SA 600 of the ICAI, which allows reliance on the work of other auditors, with the international standard ISA 600, which does not permit division of responsibility between auditors of the holding and subsidiary companies. Alternatively, regulation could require a significant majority of a group’s entities to be audited by the same auditor, as also reflected in a 2017 report of Sebi.

Restrictions on audit firm composition

The MCA paper considers limiting the number of audits and partners for a firm to improve quality. What the market really needs is capacity-building — larger firms with experience and diverse skill sets to serve large companies, whose audits demand industry knowledge, deep technical competence, and judgement. Such firms will be better able to integrate their resources and respond to emerging complexities in the framework and technology.

To achieve this quickly, smaller firms with varied capabilities need to consolidate, creating a positive correlation between larger firms and improved audit quality. This echoes the prime minister's thoughts from his speech in July 2017 on the occasion of CA Day.

Audit Quality Index (AQI)

The MCA paper deals with implementing the AQI, a framework that considers qualitative and quantitative factors to rate or rank each auditor. This was also recommended by Sebi's 2017 report. AQI will help companies identify the firm(s) most suited to audit them.

Relevant, objective parameters need to be considered in developing the AQI framework, complemented by specific needs determined by company boards or audit committees. Firms can also be mandated to publish information (transparency reports) containing qualitative and quantitative information necessary to understand their processes and other inputs for AQI.

The AQI alone could perhaps replace many other proposals in the paper. Implemented properly, The AQI will lead to consolidation of smaller firms and building capacity, resulting in a natural "panel" of firms, without regulator intervention -- a self-balancing free market. It also means fewer firms for the regulator to regulate, leading to better quality regulation.

There may also not be a need to restrict the number of audits by a firm, or the number of partners per firm, as long as the AQI score of the firm is high, and there is a healthy partner-to-client ratio. It will also ensure that the experience of a firm’s partners reflects the complexity of audits and the number of clients of the firm. Companies, including unlisted companies, will have the benefit of choice when selecting their auditor, based on the AQI and their own needs.

Continuous engagement

Over the years, corporate failures, sudden auditor resignations, and other market events have led to a negative perception of auditors as a whole, resulting in a significant trust deficit between auditors and regulators. Fortunately, this situation can be repaired by greater engagement.

The paper recommends deterring improper audits through inspection. This is indeed the right direction. Auditing involves the application of skill, expertise, judgement and experience; and goes beyond a checklist. Inspections, therefore, should be robust, carried out by competent, experienced auditors, and go beyond audit files to cover the firm's quality-related processes. To strengthen inspections and provide a reasonable and practical perspective, the regulator can engage experienced audit professionals, on the lines of what the PCAOB (Public Company Accounting Oversight Board) has successfully done over the years.

In the US and the UK, regulators invest significant effort in understanding auditors' methodologies, inspections, assessing emerging audit risks and auditor responses, discussing newer approaches to audit, etc. The auditor also needs to know that the regulator is engaged, aware, and constantly monitoring the auditor. For this to be successful, trust, open-mindedness and a quality-oriented approach are needed on all sides.

There needs to be a lot of engagement among the key stakeholders — auditor, auditee and regulator — to make this work. It takes two hands to clap, but these three stakeholders to build trust and improve audit quality.

(The writer is partner, SR Batliboi & Associates LLP)