If Satyam scam had happened in US, the auditor would have been decimated

Published: November 22, 2016 6:16:11 AM

Competition breeds efficiency; this is a fundamental maxim. Competitive forces have to be nurtured, developed and protected in the interest of capital markets.

Competition breeds efficiency; this is a fundamental maxim. Competitive forces have to be nurtured, developed and protected in the interest of capital markets. An essential limb is freedom to procure services from amongst a number of efficient suppliers and not restricted to a few. The Expert Group constituted by the government, headed by Ashok Chawla, tasked to develop a framework for the audit profession’s balanced growth. Timely action by putting amended Rules by March, 2017 is necessary. Prime data states “BIG-4 increase dominance”. This does not include large number of non-listed MNC companies in India (or PE Investee Companies which are not listed).

Trends in other countries portend the future in India. In UK, Big-6 audit all FTSE350 companies. Post 2008 recommendations on re-tendering of audits, they have moved mainly between BIG-6. In France, in CAC 40 index companies, in 2003, Big-4 plus ten non-Big-4 were joint auditors; by 2013, only Big-5 were auditors of these companies. The trend is ominous. To ensure independence, France made it mandatory for consolidated accounts to be audited by joint auditors. In the FRENCH SBF 120 index (with 250 listed companies), now, 11% of the companies have the second auditors from outside Big-5. In Singapore, all listed companies are audited by Big-5 (including one local firm).

The BOCCONI report (in Italy) on Mandatory Audit Rotation suggests that concentration increased between 1997 to 2004 from 84% to 95% with Big-4. Prime Data survey showed that 65% of the 1,480 companies stated that in rotation, they would prefer to appoint large audit firms with international presence. Technically, the profession in India is strong. Yet, it is at a cross roads due to factors beyond its control. Some support will make it vibrant.

China saw the same trends emerging. It initiated a state policy to (a) identify and support local top-100 CA Firms; (b) help ten best firms to grow to be international competitors to the Big-4; (c) support their export of services even with funding for foreign offices. It is reported that they have banned the use of foreign brand names by Big-4 in China.

Such concentration reduces choice for the auditee; increases his cost by 2.5 times as per IIM-Ahmedabad Study; and a Big-6 appointment has no visible impact on the share price. With large consultancy services being offered by MNC consulting companies associated to Big-6, their consultancy fee outgo increases. With competition reducing, audit efficiency falls. If Satyam scam had happened in the US, with class action suits, the auditor would have been decimated reducing Big-4 to Big-3. Recently, the European Commission came out with new rules on ethics to ensure independence and restriction on consulting work.

The adverse impact on Indian audit firms are manifold. The proportion of good companies in mid-size audit firms portfolio reduces; the risk level becomes much higher; good partners and audit staff are drawn away at double remuneration; in many cases, the firms agree to be indirectly taken over by MNC, e.g., PC Hansotia & Co, Dalal & Shah; Kalyaniwalla & Mistry (which again became independent); and SV Ghatalia & Co etc.

It will whittle away the independent medium size firms’ capacity to do large audits. Such concentration of work with Big-6 destroys competitive efficiency as well as choice for the service user. As the IIM-Ahmedabad study shows, costs go up.

Enron saw the collapse of a Big-5; another Big-4 collapse would have destroyed choice for the auditee; and competition amongst the auditors.

Equity capital inflow jumped post-1991 liberalisation from about 1995. With funds from private-equity (PE) investors, venture capitalists (VENCAPS), FDI and international banks, came restrictive covenants, inter-alia, demanding MNC audit firms. The second wave started last year due to auditor rotation provisions which were optional from 2013 to 2017. Prime data press note dated September 19, 2016 shows that in FY16 compared to FY15, listed companies audited by Big-4 went up from 377 in 2014-15 to 403 in 2015-16 amongst the 1,480 NSE-listed companies. They audited 234 of the 500 Nifty companies, i.e., 47%; and these would comprise a large part of turnover being the larger companies.

The impact of restrictive shareholder covenants; and of rotation will not be the broad-basing of audit services but more concentration. It reduces capacity of good Indian audit firms. Thus, one day, we will mirror the London, New York and Deutsche Stock Exchanges where only the Big-4 audit the listed companies. CAC-40 index standalone companies in France are now audited only by Big-4.

The ICAI rules compound the problem. While the Big-6 advertise and canvas through their consulting companies, the mid-size Indian audit firms are subject to strong anti-advertisement and anti-marketing rules of ICAI. More importantly, the MNC audit firms consultancy companies have brought in men and capital resources for takeovers, new offices and growth; thus, benefiting the MNC audit firm. As the MNC audit firm is appointed due to external pressure, they demand much higher fee which gives them muscle power to draw away people from mid-size firms.

If the midsize Indian audit firms are given a level-playing field, they can generate resources, keep good staff, invest in technology development and build foreign networks by tying up with mid-tier accounting networks to service Indian companies going abroad.

By issuing appropriate rules for auditor appointment in large companies, ministry of corporate affairs (MCA) can provide that in any company if the auditor is from Big-6, the second should be non-Big-6; the audit fee should be divided equally so that the MNC auditor divides the work equally. This will lead to the Indian firms developing audit capacity for very large companies and with financial resources to attract, train and retain partners and staff.

Mid-tier networks do not have common ownership or management or control unlike Big-6; but they do have regular training programmes and compulsory quality reviews. A firm has to leave the network unless they constantly upgrade quality. The ICAI Rules must distinguish these mid-tier networks from the Big-6 Networks controlled from outside, e.g., both in PWC and KPMG, international partners had deep involvement in managing crises situations of Satyam and partner exodus.

ICAI must also issue a revised circular on undercutting of fee. It was meant to allow the non-MNC audit firms to quote fee below the MNC firms. But, it has inadvertently allowed all firms, including MNCs, to quote below the existing auditors quote. The MNC auditors quote a low audit fee for entry into good business house and hunt for consulting assignments where profit margins are much higher.

Government, under the FEMA laws and permissions, should direct all consulting companies which are part of a Big-6 accounting-cum-consulting network to immediately register with ICAI and become subject to its ethics and discipline. Separate rules can be made.

Besides, adequate rules have been issued by ICAI regarding responsibility of joint auditors. The Chawla Committee needs to mandate the appointment of joint auditor from outside the Big-6, wherever the Big-6 are appointed by suitable changes in auditors’ appointment rules; and for compulsory registration of Big-6 consultancy companies with ICAI. A suitable CA services export promotion scheme needs to be framed.

With mandatory rotation due in 2017, the consequential effect will immediately whittle away the MS Firms’ capacity to do large audits. Urgent action by the government is called for and the Chawla Committee is most timely. Rules must be issued before February, 2017.

By- KS Mehta

The author is the managing partner, SS Kothari Mehta & Co.

Views are personal

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