Truth & fairness of the auditing profession

Until earlier this month, one of the most farcical professions was auditing. Under the Companies Act, almost all types of companies have to get audited. Then the charade begins. Auditors are supposed to be appointed by the owners — the shareholders — and not the management. But as anyone knows, in all private companies and most public limited ones, it is the promoter families that control both the management and the shareholding. In a tiny number of listed companies where promoters do not have a majority stake, only the management selects the auditor, and outside shareholders are too uninterested to appoint or change auditors. Hence the first ground rule of auditing is “don’t rub the managements the wrong way”.

 
What makes life easy for auditors is the second ground rule — they are supposed to be watchdogs, not bloodhounds, in the memorable phrase of Lord Justice Lopes, who ruled in the Kingston Cotton Mills Co (1896) case. A third ground rule makes life even easier: Auditors are supposed to express an opinion on the true and fair view of accounts. The audit report is merely an opinion, not a certificate or a guarantee of anything. These three ground rules defined the (in)effectiveness of auditors for generations.
 
This isn’t a story of small companies and small auditors alone. When Tata Finance was involved in huge speculative market operations, circular transactions and other suspect deals in early 2000s, the Tatas commissioned A F Ferguson to do a special audit. The Ferguson report, supervised by senior partner Y M Kale, did not give a clean chit to Tata directors. The Tatas rejected the report and Ferguson, heavily dependent on the Tata group for its revenues, sacked Mr Kale.

 

The system allows for redress against misdemeanours but only on paper. You could complain to the professional body, the Institute of Chartered Accountants of India (ICAI), against “professional misconduct” but I know of cases where the ICAI disciplinary council sided with the auditor (who of course had helped bury the accounting fiddle-diddle). Insiders know how this works, so many bright CAs stay away from auditing. The ethical ones (and there are many) feel frustrated.
 
Earlier this month, in a stunning turn of events, two sleepy but potentially powerful arms of the government changed the rules of this cosy game. On June 11, the Ministry of Corporate Affairs (MCA) moved the National Company Law Tribunal (NCLT) to debar auditors of IL&FS Financial Services (IFIN) — Deloitte Haskins & Sells and BSR & Associates — from doing any business for five years for their alleged collusion with the IFIN management. BSR is part of the mighty KPMG network of accounting firms. The MCA’s move came after a sterling job done by another organisation, one whose existence we tend to forget — the Serious Fraud Investigation Office (SFIO). It alleged that the IFIN auditors connived with former directors to conceal information about wrongdoing. All this has started to have a salutary effect. Price Waterhouse & Co, another giant in audit, tax and consulting, (banned in 2018 for two years by the securities market regulator for its role in the Satyam scam), resigned as statutory auditor of Reliance Capital in June. It claims that the company “prevented it from performing its duties … and exercising independent judgment”.

 
These episodes have come at the right time as institutional change is already underway with the establishment of the National Financial Regulatory Authority (NFRA) to regulate audit, accounting and financial standards. The ICAI opposed the NFRA tooth and nail from 2010 till 2017. The ICAI argues it is a world-class regulator and the NFRA will only impose additional costs, will create multiple regulatory bodies, and will not have competent staff in adequate numbers. But the general perception is that the ICAI has failed as a self-regulatory organisation and so the NFRA is a reality.
 
Keep up the momentum

 
Auditors help regulators, the government, investors, bankers and the public at large, not just the shareholders who appoint them. Hence, the current clean-up drive is badly needed and must be sustained to ensure that it is not limited to a few incidents that penalise just a few high-profile accountants. The first step would be to empower thousands of smaller CAs who want to act independently, but are at the mercy of promoters/managements. I personally know that when CAs set up shop, all of them are keen to do a professional job. They don’t want to be part of accounting fiddles. They need to see that the NFRA succeeds and witness the triumph of fairness and truth in their own profession.

 
The second step would be to raise auditing standards. For instance, the Securities and Exchange Board of India is thinking of making the auditor of parent companies responsible for the accounts of subsidiaries. Other countries have also slowly moved away from the watchdog metaphor and now demand a far greater duty of care. The third step would be to impose special standards for auditors of financial firms, where fragility is the highest, because they are always playing with large sums of other people’s money. Lord Denning wrote about auditors in 1958: “To perform his task properly he must come to it with an enquiring mind — not suspicious of dishonesty.” However, I suspect if Denning and Lopes were to rule today, they would say when it came to banks and financial institutions, auditors should be bloodhounds, with minds that are not only enquiring but also suspicious.

The writer is the editor of www.moneylife.in
Twitter: @Moneylifers