The case for a new framework to ensure auditor independence (Live Mint)

Mains Paper 2 : Polity
Prelims level : ICAI
Mains level : Framework needed to establish Auditors independence

Context

• Auditors in particular and the auditing profession in general have often been portrayed as the main culprits in corporate frauds and failures and alleged to have been in active connivance with the management of the concerned companies.
• This is natural because of the general understanding of the scope of an audit and an auditor’s proximity to the cause of the fraud or failure, which is usually financial.

Background

• Recent high-profile corporate collapses/frauds of the likes of Infrastructure Leasing and Financial Services in India and of Carillion and BHS in the UK have shaken the Big Four auditors.
• Regulators are debating measures such as banning these beleaguered firms and amputating the non-audit services rendered by them and are also considering various structural changes in the regulatory framework.
• The audit regulator in the UK, the Financial Reporting Council, which is akin to the recently set up National Financial Reporting Authority, or NAFRA, in India, is likely to be replaced by an authority accountable directly to the UK Parliament.
• The role of The Institute of Chartered Accountants of India (ICAI), the regulator for CAs in India, was made peripheral by the operationalization of NAFRA after the Punjab National Bank fraud.

Appointment to the auditors

• An audit is carried out in the public interest.
• The appointment of auditors and determination of their remuneration has to be totally and effectively made independent of the audited company’s management.
• Any measure short of this, like the one introduced through the Companies Act, 2013, routing the appointment of an auditor through an audit committee, or restrictions on non-audit services provided by the auditor, or requiring auditors to separate their audit and non-audit services through a so-called “Chinese wall", would be inadequate in ensuring quality audits.
• It is universally recognized that high-quality technical standards, tools and techniques are effective only if auditors remain independent and objective in their functioning and are able to challenge management decisions.

Steps needed to ensure Auditor’s independence

• Audit firms clamour for non-audit services to cross-subsidize their audit services, arguing that if they are not able to audit, quality would be the first casualty.
• The structural or operational separation of audit and non-audit services sounds sufficiently radical.
• Yet, it may not address issues of independence or conflict of interest.
• Rather, the solution lies in making audit fees remunerative indeed, commensurate with the true cost of a quality audit.
• What people expect of auditors in terms of scope and skills are on the rise. The audit fees, however, are not.
• In recent years, fees have actually shrunk under competitive pressure.
• Audit committees in general have failed to ensure that audit compensation is sufficient to cover the extra work sometimes needed when an auditor discovers things that need close inspection for example, suspect transactions.
• It is common knowledge that audit fees for bank branches in some cases do not even cover the cost of junior audit staff deployed. Unfortunately, in the ongoing debate, audit economics is not being talked about.
• Audit fees should be based on the complexity involved and work to be done.
• High quality necessarily leads to an increase in cost, but that is imperative for an audit that can be trusted. Sebi should also warrant disclosures of audit fees, skill sets deployed and hours spent on audits.

Conclusion

• This would allow us to assess the fees paid in comparison with inflation and increases in the pay packages of senior management, and also with other companies.
• Regulators should create an ecosystem where auditors do not have incentives to compromise the integrity and standards they are expected to uphold. Audits serve the public interest and their quality should concern us all.

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Prelims Questions:

Q.1) With reference to the committee set up by the Union Environment Ministry to prevent Human-Elephant Conflicts, consider the following statements:
1. Electric poles in forests and wildlife sanctuaries need to have spikes to discourage elephants from uprooting them and getting electrocuted.
2. To prevent death of animals in the forest areas due to electrocution by the distribution lines, the distribution companies shall preferably use ABC (aerial bunched cables) or underground cable.

Which of the statements given above is/are correct?
A. 1 only
B. 2 only
C. Both
D. None

Answer: C
Mains Questions:
Q.1) To what extent the regulators should create an ecosystem where auditors do not have any incentive to compromise their professional integrity. Give your arguments in this regard of this statement.