Auditing the auditors

Conflicts of interest must be avoided

The National Financial Reporting Authority (NFRA), which is in charge of supervising accountancy in India and regulates firms providing such services, in late December released a report that shook up the country’s financial establishment. The report looked at the Big Four network of accounting firms: BSR & Company, Deloitte Haskins & Sells, SRBC & Company, and Price Waterhouse Chartered Accountants. It is worth noting that some of these names might be unfamiliar because they are part of, or related to, larger global groups with a far better-known brand name. SRBC is related to EY and BSR to KPMG.
 

The fact that these companies have names different from how they are generally known is not completely irrelevant to the point that the regulator wished to make. The broad point behind accounting firms is that they must provide independent and unbiased auditing services. They are, like credit-rating agencies, a vital component of a well-functioning market. If such companies do not maintain a proper distance from the companies they are auditing or rating, problems can build up, leaving investors and shareholders unaware of them. When major corporate scandals break out, at the heart of the difficulty is often the failure of an accounting firm to identify the problem early on. The NFRA, for example, pulled up the auditors of Infrastructure Leasing & Financial Services (IL&FS) when the big non-banking financial company collapsed a few years ago. On that occasion the regulator had said the auditor did not have adequate justification for saying its audit report on IL&FS had followed the usual standards. In the present market system, auditors are the first line of defence for stakeholders.
 

The NFRA, when examining these big accountancy firms, their portfolio of businesses, and their relations with a larger group of businesses, noted this principle of independence might have been violated. The regulator’s concern is that if an accounting firm or a company in the accountant’s network earns income from consulting with a firm in other capacities, then its incentives for independence as an auditor are misaligned. A conflict of interest evolves, and that must be addressed through regulatory intervention. No specific and drastic intervention has been prescribed. But a warning shot has certainly been fired at the big firms, particularly in the context of Section 144 of the Companies Act, which specifically bans accountancy firms from offering non-audit services to their audit clients. The grey area is what happens immediately before and after an accountancy firm becomes an official auditor to some client, and whether other companies in their network group can offer such non-audit services instead.

Even if efforts are made to keep the audit and non-audit offers in a network separate, the history of such “Chinese walls” is not encouraging. In the case of BSR, for example, the NFRA has specifically said that its claims to being an entity separate from those parts of the KPMG India network do not stand up to scrutiny. The regulator’s observations and some of the auditors’ reactions suggest there is scope for improving regulatory and legal clarity. Some of the companies have been given time to clean up their act. There is, however, no doubt about requirements for a complete separation of the audit business and other functions.