MCA’s Proposals For Auditors: Some Will Manage Optics, Others Are Dangerous, Experts Say

Predicting probability of default, borrowed funds utilisation, joint audits—will these MCA proposals ensure audit quality?

Audit (Source: Pixabay)
Audit (Source: Pixabay)

Probably anticipating the impending changes in the audit profession, Price Waterhouse India and Deloitte have decided not to offer non-audit services to audit clients. In June last year, Grant Thornton, too, had said that it won’t provide non-audit services such as consulting and transaction advice to listed companies audited by it.

The move assumes significance in the light of the recent proposals by the Ministry of Corporate Affairs to enhance audit independence and accountability. The key proposals by MCA include:

  • Reducing the economic concentration of the Big 4 (EY, PW, Deloitte and KPMG) by expanding the scope of services that an auditor cannot provide to its audit clients. Currently, the list includes accounting and book-keeping services; investment advisory and investment banking services; outsourced financial services and management services.
  • Reducing the risk of over-familiarity by mandating joint audits for bigger companies.
  • Mandatory comment of holding company’s auditor on accounts of subsidiary companies.
  • Making concurrent audit mandatory for listed companies, under which the auditor will have to examine financial transactions and utilisation of borrowed funds.
  • Disclosures in the audit report on the probability of default— i.e. an estimate of the likelihood that a borrower will be unable to meet its debt obligations.

BloombergQuint asked auditors if these proposals will address the credibility crisis facing the audit industry or if they’ll merely manage the optics.

The Problem Of Economic Concentration

KPMG, EY, Deloitte and PW will handle the audits of 283 companies in the Nifty 500 Index for 2019-20, as per NSE and Prime Database Group’s estimates. Even in the broader universe of all listed firms on the NSE, the Big 4 are auditors for 26 percent of the 1,813 companies.

To reduce the dependence on the Big 4, the MCA has floated certain ideas—the number of audits under one audit firm or auditor be reduced; the number of partners under one audit firm can be reduced or fixed; auditors in listed companies can be appointed from a separate panel of auditors prepared by the National Financial Reporting Authority.

Deloitte India’s PR Ramesh says some of these suggestions will only manage optics. The way to address concentration is not to make the big small—there cannot be a single cap on the number of audits but market share on a graded subset basis, he emphasises.

For instance, you can say, for the top 50 companies by market share—the Big 4 cannot have more than 80 percent market share. So each of the Big 4 will be able to audit only 20 percent of the top 50 companies. Similar thresholds can be provided for top 100 or 200 companies and so on with the share being progressively reduced for the large firms.
PR Ramesh, Partner, Deloitte India

In this way, the big firms will take on audit of bigger companies, clearing the space for other firms to progressively grow their size and share.

Santhanakrishnan S, managing partner at PKF Sridhar & Santhanam, says that the Big 4 could also be restricted to audit companies having a net worth of, say, Rs 1,000 crore or more.

Today, because of mandatory rotation, the Big 4 are going after companies of all sizes. In that sense, rotation hasn’t helped the cause of smaller firms.
Santhanakrishnan S, Managing Partner, PKF Sridhar & Santhanam

The concentration issue is as a result of foreign investors’ insistence on a big/international auditor, points out Vishesh Chandiok, CEO, Grant Thornton India.

In 2018, the government tried to address this by mandating in the FDI policy that where a foreign investor has specified appointment of an international network audit firm, the investee company must appoint another firm that’s not part of the same network. There is little evidence of this being followed—so the focus needs to be on implementation, and clarifying such current regulations versus introducing further changes, Chandiok adds.

Joint Audits: Is Four-Eyes Principle A Good Idea?

Joint audits would be beneficial in reducing the risk of over-familiarity through rotating the allocation of fieldwork between the joint auditors after a set number of years, the ministry’s proposal says. While it’s not mandatory, most public sector companies have two or more auditors.

Last year, U.K.’s Competition and Markets Authority also recommended joint audits to enable firms outside the Big 4 to develop the capacity needed to review the biggest companies.

But Ramesh believes that this proposal comes with the inherent issue of lack of accountability. There’s another proposal that the holding company auditor should be accountable for subsidiary companies—that means if you’re the auditor of the holding company that has 10 subsidiaries, you’re liable for all. Read with the joint audit proposal, there will be inherent contradiction.

In a joint audit, one auditor will be responsible for his half. But in the same breath, you’re saying as an auditor of the holding company, you’re responsible for the subsidiaries as well. If you want me to be responsible for all, then why do you recommend a joint audit where accountability is 50 percent or one-third if there are three joint auditors? 
PR Ramesh, Partner, Deloitte India

But Santhanakrishnan stresses on the benefits of this proposal, saying via joint audits, one auditor can catch what the other has missed.

Take, for example, ONGC that has four regions: north, south, east, west. You can have joint auditors who rotate across these regions. If I miss something, next year the other auditor will catch it, and deficiencies will come out.
Santhanakrishnan S, Managing Partner, PKF Sridhar & Santhanam

Concurrent Audit: Shifting Oversight?

Concurrent audit is a systematic and timely examination of financial transactions—the emphasis is not on test checking but on substantial checking of transactions. The ministry asks if auditors be made responsible to check the utilisation of borrowed funds in listed companies.

Both Ramesh and Santhanakrishnan say it’s a bad idea—the auditor is not the panacea for all wrongs.

The proposal seeking to address the issue of diversion of funds is challenging, Ramesh explains. Funds are fungible—let’s say a company has borrowed Rs 100 crore and puts it in the bank. “The company makes a profit of Rs 100 crore and parks that with the bank as well. The Rs 200 crore are now mixed—what funds have I used for what purpose?”

“To determine this will be far more complex in actual practice where funds could be utilised through layers of subsidiaries—where I may not be the auditor—or other normal business transactions,” he says.

Ramesh adds that while the objective is appropriate but the audit profession should determine how this can be effectively done given the limitations of scope, that is, audit not being a forensic assignment, time and coverage—for example, sampling of transactions.

This clearly requires a larger debate as it is a significant change in expectations—in substance, it is an assurance of absence of fraud.
PR Ramesh, Partner, Deloitte India

“Why aren’t the lending institutions being asked to take this responsibility?” asks Santhanakrishnan.

Probability Of Default: Dangerous Suggestion?

Probability of default is an estimate of the likelihood that a borrower will be unable to meet its debt obligations. And rating agencies, due to inherent conflict of interest, have lost credibility on this front, the MCA proposal says. And so, it asks, should auditors be asked to make this assessment and disclose it in their audit report?

This is a terrible suggestion—the responsibility of the auditor is not only to publish correct accounts but also not to create panic in the market, warns Santhanakrishnan.

After looking at the balance sheet of, let’s say, a real estate company, I come to the conclusion that the probability of default is 40 percent, and start providing for it. Is it not similar to an astrological prediction? Let’s say, an oil company hasn’t found gas and I estimate the probability of default to be some percentage—the stock reacts—and then the company finds gas. The probability of default will come to zero.
Santhanakrishnan S, Managing Partner, PKF Sridhar & Santhanam

But, you would have created huge volatility in the market, he adds.

Finally, Chandiok proposes allowing for multi-disciplinary partnerships—something that hasn’t found a mention in the ministry’s proposal.

Multi-disciplinary partnerships have been in the works for years but still not permitted. To enhance audit quality, professionals like lawyers, information technology specialists, cyber practitioners must be allowed to become partners in CA firms, Chandiok says.

The ministry has given stakeholders time till Feb. 28 to submit their suggestions.

(EY, KPMG, PW declined to comment on this story.)