Need For Quality Audit Framework in India

Why do you call an accountant with an opinion?

An auditor. ;)

As old as that joke is in the accounting world, even older is the Reserve Bank of India’s calls to strengthen audit systems in the country. Yesterday was yet another such exercise when the Governor advocated for the need to boost India’s auditing framework so as to facilitate the creation of a “resilient and dynamic” economy.

Remarks like this have become increasingly common in light of the rising complexities of the world’s financial markets and an unfortunate rise in the cases of financial frauds that have dented the Indian economy lately.

Let’s see how having a robust auditing infrastructure supplements the growth machinery and financial sector’s integrity in a country. We will also delve into the cases where the absence of proper auditing mechanisms have left an urgent need to create them in India.

The Scales and Standards

What is an audit, exactly? It is basically (a) the inspection of various “books” of accounts, and (b) the physical inspection of inventory of an organisation to ensure that all departments are following the accurate systems and documented procedures of recording transactions.

Now, there are different types of audits that are specified for different purposes and entities — compliance, financial, tax, IT, internal, operational, investigative etc. The idea is to improve the quality of practice followed by accountants in organisations and ultimately cement public confidence in financial reporting.

In India, the Institute of Chartered Accountant of India (ICAI) has formulated and released standards for auditing as well as quality control which are in line with international standards.

FYI: ICAI is a statutory body — set up by an act of the Parliament.

But the issues arise with the proverbial too many cooks spoil the broth situation. There are multiple regulators — ICAI, NFRA, RBI, SEBI, IRDAI, IBC — to deal with audit failures in India. So even if the issuance of norms is uniform, their enforcement runs into a regulatory minefield of sorts. Tweet This

And this isn’t the only issue. Independence of audits, which is the cornerstone of the exercise, falls into peril routinely which then leads to unchecked related-party transactions. In the banking sector, especially, these transactions have been responsible for scandals amounting to crores putting both public and private finances at risk.

The Attempted Correction

Due to the above errors, the RBI took an emphatic step and issued a set of new guidelines between February-April 2021 to increase auditor independence (link to press release). The guidelines can be summarised as follows:

• Lenders with assets over ₹15,000cr ($2bn) will hire at least twodifferent audit firms (with no mutual affiliation) to conduct their audits.
• Those with assets over ₹5trn ($66.6bn) can hire up to 4 and those over ₹20trn ($266.7bn) can hire as many as 12 auditors.
• All the above appointments will be for a three-year term at a time and must be rotated thereafter (no consecutive terms).
• Banks will need RBI’s approval for appointment and reappointment of statutory auditors on an annual basis.

It’s important to note that these guidelines are aimed at boosting the internal audit functions of banks (primarily), NBFCs, UCBs (Urban Cooperative Banks) and HFCs (Housing Finance Companies). It is part of the RBI’s Risk-Based Internal Audit (RBIA) framework (started in 2002) which seeks to improve their governance, risk management and control processes.

This measure has meant different things for different groups.

For Audit Firms

Post-liberalisation, the audit industry largely passed into the hands of the Big Four (Deloitte, KPMG, PwC and EY). But with the new guidelines, the RBI has brought changes to two main areas — joint audits and ceiling on audits.

Both these changes are vehemently opposed by the Big Four since the new rules will bring in more diversity in the audit pool for entities with the biggest asset sizes, thereby capping the Big Four’s presence.

Also, the mandated three-year change in auditors could push costs up by 10–30%.

For NBFCs et al.

The banking and non-banking fraternity are also not big when it comes to supporting the new guidelines because they involve switching statutory auditors in the middle of the financial year. They believe that a policy measure such as this should not be applied retrospectively without allowing for a reasonable transition period to plan the compliance framework.

Plus, it would also put constraints on the management’s bandwidth due to the disruptions caused by the pandemic.

The Holdout

The guidelines were a well-intended policy shift to contain the potential collusion between auditors and banks that has notoriously compromised audit quality in the past.

But at the end of the day, auditors are paid by the very companies whose financial data they examine. Sometimes other departments of the audit firms are offered add-on service contracts or other perks from the examined entities which escalates the conflict of interest even further.

And nothing in the new auditing guidelines attempts to rectify this.

That said, with two different firms on the payroll, the chances of neglecting glaring errors and red flags in the data may be reduced to some extent by limiting the “captive auditing” process. In addition, formulating a risk-based audit plan, which remains central to the RBIA framework will also help acknowledge the inherent business risks from the departments and activities which drive them.

The RBI has been very clear that internal audit functions should not be outsourced but carried out by experts (including former employees) hired on a contractual basis. Especially when it involves specific subject-matter expertise in areas like information systems, technology, data localisation and storage etc. It is the lack of these resources that led to the RBI ordering independent/external/supplemental audits for entities in the past (e.g. HDFC Bank, Mastercard).

However, independence of auditors cannot be achieved without addressing their revenue dependence, the one variable that determines objectivity in their analysis. Rather than mandating multiplicity of auditors, what the RBI can do instead is mandate the audit firms to disclose the degree of their revenue dependence.

The creation of an independent autonomous board to oversee the role of auditors (like the ones created in the US under the Sarbanes-Oxley Act post the Enron scam) will also go a long way in promoting discipline among them.

The winds of investor enticement towards India cannot be made to change course favourably without assuring the investors of the audit quality, which in turn, will determine the raising of capital for growth.

(Originally published November 8th 2021 in transfin.in)