Reaping The Whirlwind

Updated: Jul 30 2003, 05:30am hrs
According to reports published in all economic and financial newspapers, on the night of 22 July, the Council of the Institute of Chartered Accountants of India (ICAI) passed, by a single majority, a resolution in favour of compulsory rotation of auditors. The proposers of the resolution in favour of compulsory rotation seem to have done it very cleverly. It has been brought in as a matter related to the Code of Conduct of ICAIs members - which can be enforced internally by the Institute, irrespective of what the Companies Act, 1956, has to say.

ICAIs council was clearly split in the middle, which is evident from the fact that the resolution got passed by just one vote. Moreover, it would seem that the council is not too sure of its hairs breadth majority, because Mr R Bhupathy, the President of ICAI, has told financial papers that there will be a referendum on this issue - to be voted on by over 110,000 chartered accountants throughout the land.

An even more interesting news was the decision of my friend, Mr Rajiv Mehrishi, joint secretary, Department of Company Affairs, to abstain from voting on this issue. While I can understand the general principle of a government nominee on the council or board of an organisation abstaining on matters that do not concern the government, I am surprised at Rajivs abstention in this particular instance. He was, after all, the member-secretary of the Naresh Chandra Committee, that produced a unanimous report which, among other things, categorically vetoed the idea of compulsory rotation of auditors.

I truly wonder why someone who argued against compulsory rotation in the Naresh Chandra Committee could decide to remain silent when this issue came up for debate and voting in the ICAI council. Nothing has changed between now and the publication of the Naresh Chandra Committee report in November 2002. Why then, for Rajiv, was rotation a bad thing then, and a neutral non-issue now - one that narrated nothing more than an abstention

Frankly speaking, Rajivs not voting on July 22 is in the nature of a curious aside. Far more central is the absurdity of this retrograde decision taken by ICAIs council. Let me share with you the reasons why compulsory rotation of auditors will not only be counterproductive, but will also ensure that audits degenerate to the level of the lowest common denominator.

The Naresh Chandra Committee had carefully listened to the minority, which advocated rotation of audit firms, and the overwhelming majority which opposed it, but argued in favour of the rotation of audit and engagement partners. Moreover, the committee had debated long and hard on the subject. The arguments against compulsory rotation of audit firms were very convincing.

To begin with, it needs to be recognised that auditing multi-divisional, multi-segmental companies in todays complex and rapidly changing business environment requires high levels of financial skills as well as detailed, industry-specific knowledge. Such knowledge doesnt drop like manna from heaven. It requires sustained training and exposure, deep understanding of business practices, as well as expertise on changing accounting rules and standards. To give an example, income recognition is a critical factor for global IT services companies. One needs to be fully cognisant of the different types of IT services business conducted in a single company - and the different methods of recognising such income - before one can arrive at a true and fair view of the financial health of the audited entity. Accountants, however good they may be, are not expected to immediately and instantaneously understand the intricacies of IT services, BPOs, research and development expenses of pharmaceutical companies, or the liabilities, assets and income implications of complexly structured joint ventures and special purpose vehicles. Such knowledge develops through practice arising out of a long association with client companies. And, as we go forward, this kind of detailed corporate knowledge will delineate the difference between top-class, knowledgeable auditors and mere accountants.

Clearly, compulsory rotation of audit firms once every five years destroys this key requirement of building the knowledge base. In fact, compulsory rotation has far worse outcomes. If I, as an auditing firm, know that my contract is going to be compulsorily terminated at the end of this year, then what incentive do I have to put my best foot forward in auditing Clearly there is no positive incentive whatsoever. Not surprisingly various independent academic studies conducted by professors in accounting and finance department of international universities have consistently shown that rotation tends to significantly enhance the risk of audit failures during the last year of the tenure of the outgoing auditor (who has no further incentive to invest in quality), and the first two years of the new auditor (who has yet to fully understand the details of complex business).

This was recognised even by the Sarbanes-Oxley Act. While section 203 of the Act prescribes the rotation of the lead or coordinating audit partner, or the audit reviewing partner, once every five years, it does not mandate compulsory rotation of audit firms. If, in the politically super-charged post-Enron era, US law makers could see reason, I fail to understand why ICAIs council could not.

Come to think of it, I can hazard a pretty good guess about why many of ICAIs members want compulsory rotation of auditors. Over the last fifteen years the Institute has been increasingly dominated by partners of small audit firms, many of whom have done a great deal of lobbying and political canvassing to get themselves elected in the council and other governing bodies of ICAI. They see a threat to their livelihood. And one way of ensuring some business is to mandate compulsory rotation of audit firms.

Unfortunately, their self seeking objectives are unlikely to be fulfilled. The dysfunctional consequence of compulsory rotation will be that the top 25 or 30 audit firms will each create two to three sub-firms - and the client will happily rotate amongst them. That, of course, is a sub-optimal outcome, but it would seem in ICAI care.

Over the last two decades, reputed chartered accountants have played a lesser and lesser role in ICAIs affairs - claiming that they are fed up with institutional politics and that they had better things to do. They abdicated their position, making way for an army of mediocrities. Now the mediocrities have struck back, and the good and glorious are crying for help. The moral: If you want institutions to succeed, dont abandon them. Or else, reap the whirlwind.