Audit rot

There is structural problem with auditing in India

The Union secretary for corporate affairs has warned that the firms auditing group companies of troubled Infrastructure Leasing & Financial Services (IL&FS) have “many questions to answer” regarding the build-up of irregularities within that group. The secretary also said while the government was not expecting an auditor to detect a needle in a haystack, they ought to find if “an elephant is in the room”. IL&FS’ debt is reportedly over Rs 94,000 crore, but there was little suspicion of the scale of the problem prior to some group companies defaulting on repayment last year. Since then, the board has been replaced and an investigation has been started by the Serious Fraud Investigation Office. The auditors themselves are being investigated by the corporate affairs ministry’s National Financial Reporting Authority, or NFRA, which was notified last year. This means that the investigation of flaws in the auditing process, if any, is now out of the hands of the accountants’ own body, the Institute of Chartered Accountants of India. 

While entities related to three of the “big four” accounting multinationals — EY, Deloitte and KPMG — will reportedly be questioned, much attention will probably focus on Deloitte, which was most closely associated with IL&FS in the public mind. A previous investigation that may be relevant is into fraud at the erstwhile software company Satyam. When that was discovered, the board was superseded and eventually the auditors were investigated by the Securities and Exchange Board of India (Sebi). While that process took a long while to close, after nine years PriceWaterhouseCoopers received a sentence: It was required to return Rs 13 crore, and was banned from auditing listed companies for two years. Opinion is divided as to whether this was a harsh enough sentence. What is probably true, however, is that given that sentence was handed down only last year, a similar sentence against one or more of the other big auditors will create a supply constraint for auditing. There should therefore be no knee-jerk reaction.

However, it is also clear that there is a systemic problem in how audits are being carried out, especially by big auditors on big companies. Some auditors are paid for “consultancy” services as well. While the audit companies insist that there is no conflict of interest, the recent history of financial services suggests that such mixed incentives should not be allowed to persist. The auditors also point out they do not conduct forensic audits of the sort undertaken by criminal investigators — they largely rely on the numbers and paperwork that they are shown by the company they are auditing. However, this explanation conceals as much as it reveals. Part of the complaint against the auditors in the IL&FS case is from a whistleblower in the IL&FS management who reportedly claims that the auditors relied excessively on “management explanations and comfort letters” when the audit results appeared relatively adverse. Auditors do not serve the companies whose books they are examining, but investors and the general market. While investigations into IL&FS’ auditor should be speedy and any wrongdoing should be strictly penalised, it is important that a structural fix to all audit firms’ incentives be discussed and implemented.