The Hindu Business Line : Refocussing the audit effort

Scams will continue to happen unless audit reverts to being a profession instead of being a business. Auditors need to be paid highly, like judges, by investors by way of a levy on the shares traded. This would break the nexus between management and auditor.

THE global failure of audit is being seen as a major problem for free economies and capitalism. In the Indian scene, a few years ago, any corporate collapse was attributed to audit failure, with the reasoning that far less stringent regulations were followed compared to the US. Hence, in the last few years, the Institute of Chartered Accountants of India released a flurry of Accounting Standards, and the Companies Act was amended to say auditors shall not hold any shares.

The more investor-friendly corporates, led by the software sector, started adopting US GAAP. Companies began accepting US pronouncements and placed greater reliance on corporate governance measures. The result was an upsurge in investor interest in companies adopting corporate governance measures and US GAAP.

Overseas investors were more adventurous and willing to pay a higher price for IPOs. Thus, audits by the Big 5 were started. The Big 5 audit firms, though staffed exclusively by Indian chartered accountants in India, claimed a higher standard of audit due to the international brand.

The consequence of this changeover of audit was accompanied by the heady days of the IT and Internet boom, though many dotcoms subsequently collapsed because of faulty business models. Recently, during the sudden collapse of large US MNCs, such as Enron and WorldCom, one of the Big 5, Arthur Andersen, was held responsible and later liquidated. CEOs were thrown out on the street, there were calls for prison terms for the culprits, and so on.

Indian CAs claim that our strong sense of values, and the system, did not allow this to happen here. However, many co-operative banks and the securities trader Home Trade collapsed.

The global call for more regulation of auditors and managements is fine. But is it just a case of asking for more rules without a clear understanding of the underlying issues?

The Institute of Chartered Accountants of India's immediate reaction was that it would set up a peer review system, whereby one auditor would review the work of his colleague. The heart of the matter lies in a simple issue: Audit is a business which leads to selling more profitable tax, business consultancy, IT consultancy. Thus the Auditor was trying to milk the account.

The concept of higher revenue per customer, etc., is a far cry from the earlier days of audit as a professional calling about 40-50 years ago. Auditors then were of a genteel class, who would practice as a social calling. They were mostly small sole proprietorships and not global giants. The client company's management is under pressure to report better profits to the capital market investor. The auditor is a referee in the game between shareholders and management.

However, if the referee also tries to maximise his return on supervision, what are his alternatives? Spend less time in doing the work, delegate work to less costly staff, or charge more for services. The first two measures are easily implemented and compromise audit quality, while the third compromises the auditor's independence. Thus the auditor's search for profitable business came from the competition.

Audits are open to tender offer (openly or in camera). The auditor could have chosen a route to better profitability by making his seal of assurance very difficult to get. But open competition due to the bidding war among the Big 5 and the next tier of firms closed that avenue.

In fact, clients started shopping for cheaper, favourable opinions. Thus the audit form had to hold on to the client or lose business and shed staff. These pressures have ensured that there was a perpetual chase for lucrative consultancy contracts for management consultancy, tax consultancy, takeover, due diligence, corporate strategy, IT, recruitment, temp staffing, outsourcing of accounting work, and so on.

Further, with the attempt to minimise and focus the audit effort, the tendency was to lean heavily on making audit opinions on the basis of smaller and smaller sample checks of documents. More reliance was placed on computers, which were checked only once in a while. This was akin to checking the automobile occasionally and saying it is safe to be driven by licensed drivers.

The oldest dictum of audit was observation, whereby auditors spent time with clients. There was observation of activities, which lead to overhearing conversations between suppliers, customers, etc. Such first-hand evidence collection by suspicion could not blend with the PR needed to get consultancy work.

The auditor, in his pursuit of profitability, had also to invest in better infrastructure. Plush offices, computers, dinners and sponsorship of cricket and golf games, etc., became the order of the day. These additional costs of auditing and profit-making incentives to partners made audit a business.

Worldwide, people have gloated over failure of communism and victory of capitalism. However, both systems get shortchanged at the altar of human greed. Thus, when the investor, the businessman and the auditor all chase business growth and profits, failure is a must.

In the days of the Vijaynagar King Krishna Devaraya, the court's humorous poet Tenali Raman was hauled up for a fraudulent scheme. Tenali had collected gold vessels from citizens, who received an additional vessel from him. Hence, many persons deposited their gold and silver in the hope of additional vessels. Tenali refused to return the vessels deposited and denied any liability for vessels received or additional vessels expected, when the scheme drew lots of participants.

When the King asked for an explanation, Tenali Raman said if people believed that vessels can give birth to additional vessels, death follows. Unfortunately, all the vessels died. Hence, I am unable to give either the vessels deposited or any additional vessel. The King understood Tenali's intention of exposing his and the citizens' foolish greed, and thanked him for opening his and their eyes.

Scams will continue to happen, unless audit reverts to being a profession, instead of being a business. Auditors need to be paid highly, like judges, by investors by way of a levy on the shares traded. This would break the nexus between management and auditor.

Further, the auditor should be banned from taking any other assignment from the client. The so-called professional institute policing the members is a fig leaf. This cover gets blown in India in the face of the vanished companies and the scams.

In spite of all the events, from the Harshad Mehta days to date, no Indian auditor has been liquidated, whereas Enron is over, and so is Arthur Andersen.

The Institute of Chartered Accountants in India, cannot take comfort in the lack of indictment. In fact, Cogentrix and Arthur Andersen both lost the case filed in the Karnataka High Court in a public interest litigation against the project.

And so do the stories and scams continue. In response, new regulations and safety nets are put in place. But there is no system of redressal possible against sheer greed.

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