MCA’s Proposals for Overhauling the Audit Industry

In corporate governance parlance, auditors are considered to be key “gatekeepers”. However, governance failures both in India and around the world have pointed fingers towards the role of auditors. This has led to a series of reforms that impose greater stringency on auditors and the audit process. For example, the audit provisions in the Companies Act, 2013 (the “Act”)  have been designed bearing in mind the lessons from the Satyam episode. However, more recent events such as the implosion of IL&FS have exposed the inadequacies of even such a reformed system. This has led to calls for imposing further restraints on the audit provisions in the law.

As a step in this direction, the Ministry of Corporate Affairs (MCA) on 6 February 2020 published a consultation paper to review the existing law and suggest reforms to enhance audit independence and accountability. In this paper, the MCA identifies current shortcomings with auditors and the audit process, and raises several questions for consideration. It solicits views and comments on its proposals from various quarters. The issues that MCA touches upon and the proposals it places for consideration are significant and, if implemented, will bring about a significant change to the audit industry and also to the way in which auditors operate as gatekeepers in corporate governance. This post briefly outlines some of the key areas that merit discussion.

Threats and Responses

The consultation paper identifies several threats that could arise from the operation of the audit industry. These include:

  • Self-interest threat, whereby auditors rely on their clients for fees, thereby impinging on their independence;
  • Self-review threat, where an auditor may review financial statements that it prepares itself;
  • Advocacy threat, by which an auditor is involved in resolving disputes on behalf of its client;
  • Familiarity threat, which is an offshoot of an unduly longstanding relationship between and auditor and its client; and
  • Intimidation threat, wherein an auditor may suffer intimidation from the client’s management or directors that may impinge upon its independent decision-making.
As the paper goes on to note, these threats have been an integral part of auditor failures in recent high profile instances involving Indian companies. After reviewing the current regulatory regime, the MCA proposes a whole range of reforms to mitigate the risks arising from the abovementioned threats. These include prohibition on non-audit services, stringent quality review, rotation of audit partners and even appointment of auditors by external authorities. Thereafter, the paper goes on to propose several other targeted measures.

Oligopolistic Nature of the Audit Industry

MCA’s reforms are targeted not only at the processes, but at the audit industry itself. One of the key concerns regarding the industry, not just in India but elsewhere in the world, is that it is dominated by the Big Four players. More specifically to India, the tenor of MCA’s consultation paper indicates the need to develop a robust homegrown audit sector to effectively compete with the large global players. Suggestions have been sought on how to prevent concentration in the industry.

Non-audit Services

The fact that auditors provide a varied range of non-audit services to their audit clients has always been a source of concern for the regulators. Under the current regime, auditors are prohibited from providing a range of services specified in section 144 of the Act and the Companies (Audit and Auditors) Rules, 2014 (the “Rules”). The tone of MCA’s proposals is to expand the list of prohibited services. Hence, rather than to ban non-audit services altogether, the proposal is to further limit the types of services that can be provided.

Joint Audit

Joint audit has come to be an important tool by which some of the concerns relating to the audit process and industry can be addressed. At present, the Act and the Rules stipulate a voluntary mechanism for joint audits. MCA’s proposal is to consider whether this must be made mandatory for large companies beyond a certain threshold to be prescribed. [It is worth noting, from a comparative perspective, the efforts by the Singapore Exchange Regulation to consider the appointment of a second auditor in exceptional circumstances].

Holding and Subsidiary Companies

The fact that several leading Indian companies operate as part of a larger corporate group rather than as standalone entities raises important questions when it comes to audit. This issue has been exacerbated in recent governance episodes where subsidiaries have been involved in questionable transactions that ultimately impact the parent and its shareholders. The concept of consolidation requires the auditor of the parent company to consider the subsidiaries’ accounts as well. But, what is unclear is the extent to which the parent’s auditors need to review the underlying working papers relating to the audit of the subsidiary.

Panel of Auditors

Under the current disposition, the management proposes the choice of auditors, who are ultimately approved by the shareholders. Concerns abound that management has substantial influence over the choice of the auditors, which erodes their impartiality. The MCA proposal to address this is to create and maintain a panel of auditors. Suggestions are invited as to the methodology to be adopted for such a panel. Although not explicit in the consultation paper, the MCA seems to have drawn inspiration from a similar exercise it undertook to create a database of independent directors. However, as discussed earlier, the merits of creating such as panel- or database-oriented mechanism are far from clear.

Restriction on Number of Audit Firms

In a move that might strike at the heart of the organizational structure that audit firms follow in India, the MCA wishes to consider whether the number of audits per audit firm must be reduced, and whether the number of partners per audit firm must be reduced. This is because, although there are restrictions on both these counts, those restrictions are somewhat redundant given that large audit firms such as the Big Four “operate through a network of local chartered accountant firms”. Such a structural arrangement has perpetuated the consolidation of the audit industry in the hands of a few firms. As the consultation paper notes: “In India, 70% of the about 1,800 companies that trade on the National Stock Exchange are audited by firms affiliated to Big four, according to Delhi-based Prime Database.”

Resignation of Auditors

Recently, there have been several instances of untimely resignation of auditors, which causes significant concerns to various stakeholders. Hence, both the Institute of Chartered Accountants of India (ICAI) and the Securities and Exchange Board of India (SEBI) have taken steps to deal with the fallout of early auditor resignations. The MCA now proposes to consider whether these stipulations of the ICAI and SEBI ought to be made applicable to other large companies as well.

Other Measures

The MCA proposes other measures, including:

  • Mandatory audit engagement letter that is taken on record;
  • Concurrent audit for large companies, especially in circumstances involving utilisation of borrowed funds;
  • Disclosure on “probability of default” in loan payments;
  • Development of a composite audit quality index;
  • Deterrence measures against improper auditors through inspection of audit engagements.
Conclusion

Although audit measures have been strengthened over the years, the MCA’s consultation paper reveals a great sense of regulatory dissatisfaction over the current state of affairs. Hence, its proposals do not fall shy of targeting far-reaching and potentially controversial reforms to rein in the audit industry. Ultimately, the final outcome is likely to depend upon a cost-benefit analysis of the measures proposed. For instance, the wide-ranging reforms in the US in the Sarbanes-Oxley Act in the aftermath of the Enron scandal attracted criticism on the ground that it was overbearing in nature. More importantly, the final outcome from a political economy perspective would depend upon the extent to which the regulator is able to resist push back from various interest groups, primarily the audit industry itself.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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