Making big accounting firms fall in line

Whenever an accounting transgression takes place, regulators get into overdrive and inevitably pass some regulation (which is more a quick reaction) attempting to penalise auditors. Enron resulted in the Sarbanes Oxley Act and Satyam resulted in a Companies Act that used the word ‘imprisonment’ more liberally than ‘company’.

The IL&FS episode has resulted in multiple regulators mandating numerous regulations and the government giving powers to the National Financial Reporting Authority (NFRA).

The failure of a construction company called Carillion in the UK resulted in a spate of committees and enquiries — the John Kingman Committee, Sir Donald Brydon review and a statutory audit services market study by the Competition and Markets Authority (CMA).

Interestingly, the companies whose accounting transgressions led to the formation of so many committees were audited by the ‘Big Four’ accounting firms — Deloitte, EY, KPMG and PwC.

The task given to most committees was to recommend how audit quality could be improved and to answer the question whether too many audits are being done by too few audit firms.

Since the Sarbanes Oxley Act, recommendations have been made by multiple agencies and committees but none of all this has been translated into action. There is an opinion in some quarters that the large accounting firms wield influence where it matters, which ensures that the suggestions of any committee remain only suggestions.

The Bar Council of Delhi can lay claim to being one of the first bodies in India to initiate some sort of action against the Big 4 accounting firms in the country.

Bar Council decision

Acting on charges of surrogate law practice, the Bar Council has directed these firms to refrain from providing legal services with immediate effect until further orders. The firms have also been asked to furnish a list of all the advocates who have been engaged by them, in any capacity, in any of their offices at any place.

This decision is the result of a complaint filed by one of the members of the Council in 2015 that the firms were resorting to unauthorised practice of law by providing legal services in violation of the Advocates Act.

These firms were employing law graduates and providing legal advice, besides drafting joint venture and other agreements for clients, without registering themselves with the Bar Council of India.

The main contention was that these firms were also engaged in law practice, which is not legally permissible in India. It was submitted that there is no justification for accounting and audit firms to enter legal practice and offer non-litigation services.

Large audit firms offer an eclectic variety of services to their clients. A normal bouquet of services would include audits and assurance services, direct and indirect tax consultation, management consulting services, valuation services and — as the Bar Council of Delhi has proved — legal services.

The very nature of services offered is sufficient enough to reach a conclusion that there is a clear conflict of interest if the same firm offers more than one of the above services to the same client. The large audit firms counter this argument by stating that they have clear demarcation of duties to ensure that there is no conflict of interest. Usually, this means creating multiple structures and entities and ensuring that resources are deployed across different entities.

Yet, it is clear that these are only Chinese walls and a certain element of bias would creep in when push comes to shove. Audit firms would not want to let go off the consulting pie since the fees are much more than audit fees and the risks are far less.

Though the decision of the Bar Council of Delhi may not have pan-India applicability, it has opened the doors for others to do likewise.

CMA suggestions

Three important suggestions have been given by the UK’s CMA: auditors should hive off their audit practice into a separate entity; introducing a system of joint audits; and have a separate audit regulator.

The separate audit businesses will have separate management, accounts and remuneration, CEO and board, and financial statements for the audit practice.

The CMA also recommended an end to profit-sharing between audit and consultancy, and promotions and bonuses based on the quality of the audits. The CMA has also suggested mandatory joint audits with joint responsibility are necessary because barriers to entry for challenger audit firms are currently large.

There will be some initial exceptions for audits of the largest and most complex companies and any company that chooses a sole challenger will be exempt, but could be subject to more rigorous scrutiny. The CMA says that the new audit regulator, the proposed Audit, Reporting and Governance Authority (ARGA), should hold audit committees more vigorously to account.

This will include committees being made to report their decisions on hiring and supervising auditors and the regulator issuing public reprimands to companies whose committees fall short of adequate scrutiny of their auditors.

After five years, the changes will be reviewed with more drastic action considered if no improvement is recorded, such as a greater separation of the Big Four and moving to independent appointment of auditors.

Soft regulations such as those recommended by the CMA solve only a part of the problem. Regulators should ensure that punitive action is taken in case the audit firm is found guilty of negligence. In the case of IL&FS, a whistle-blower is said to have stated that the consolidation auditor was worried more about documenting his files with representations from the management than on enquiring and informing shareholders whether IL&FS would exist as a going concern.

Punitive action should not only be a monetary imposition but something more action-oriented, such as a ban. Just as some companies state that they are equal-opportunity employers, auditees should be in a position to state that they will provide equal opportunity to any audit firm. The onus of proving that quality audit can be done by any firm should be left to the Institute of Chartered Accountants of India and the audit firm.

The writer is a chartered accountant

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