Audit oversight key to audit independence by Ashish K Bhattacharyya

By Asish K Bhattacharyya

One of the important rights that shareholders enjoy is the right to receive financial information periodically. It is widely perceived that managers have a temptation to ‘cook’ account books and provide favourable financial information to the investing public.

Therefore, there is a need to have an independent third party, with adequate competency, to review those financial statements to assess whether they provide a ‘true and fair view’. The statutory auditor plays that important role. The auditor provides a reasonable assurance that the financial disclosures are fair and complete, and thus, enhances the investors’ confidence, which is essential to the promote liquidity and efficiency of the capital market.

Auditing profession plays a critical role in the economic development

A developed capital market ensures flow of capital to the corporate sector and efficient allocation of capital. Thus, the auditing profession plays a critical role in the economic development of a country.

It is a well-established view that the statutory auditor is the watchdog of the public interest. Yet, the auditee (the company) pays the fees. Neither the government nor the public pays the audit fees. Although shareholders enjoy the right to appoint the auditor, in practice, the management appoints the auditor.

Consequently, a fundamental tension exists for the auditor whereby the party to whom he technically owes primary allegiance is not the party who pays for his services. Thus, auditor’s independence is potentially compromised simply by accepting the audit engagement.

Bottom line is important for audit firms

Audit firms, like any other professional firms, strive for growth and intend to retain the client. Therefore, while engaged in the audit of financial statements of a particular year, it expects to get appointment for the next year. Moreover, like any other professional firm, bottom line is important for audit firms.

Therefore, they have a temptation to cut cost. As was revealed in the case of Enron, the audit techniques and procedures follo wed by the auditor (Arthur and Anderson, one of the then big Five audit firms) remained unchanged even when the audit risk enhanced significantly. This inherent tension and temptation to compromise on audit quality cannot be glossed over. Therefore, search for mechanisms to enhance auditor’s independence and audit quality continues.

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‘Peer review’ and ‘disciplinary mechanism’

It is imperative that effective oversight of the accounting profession and of independent audits is critical to the reliability and integrity of the financial reporting process. Various mechanisms exist for auditor oversight. About three decades back, auditor oversight through ‘self regulation’ was prevalent in most countries. In this regard, auditing profession was no different from many other professions (e.g., medical and legal). ‘Peer review’ and ‘disciplinary mechanism’ were some of the systems being used by the accounting and auditing profession to ensure independence and quality.

The credibility of ‘self-regulatory measures

With large-scale audit failures, the credibility of ‘self-regulatory measures’ is being questioned. Audit oversight mechanisms, which are not predominantly based on self-regulation, are being introduced as a part of the audit reform. One such system is the review of statuary audit by the audit committee of the board of directors. In USA, the Sarbanes-Oxley Act (2002) created the Public Company Accounting and Oversight Board (PCAOB). One of the PCAOB’s responsibilities is to conduct independent inspections of public company audit firms. In India, in 2007, the government has constituted a ‘Quality Review Board’.

Absence of adequate number of large audit firms

It is generally believed that rotation of auditors or lead audit partner periodically will be mandatory on the promulgation of the new Companies Act. There is no consensus that this system will strengthen the auditor’s independence and audit quality. There is a concern that, in absence of adequate number of large audit firms, Big Four will enter into a tacit arrangement to rotate audit among them. Luckily, in India, share of the BIG Four is around 50 per cent. Therefore, most companies should be able to appoint auditor of their choice. However, they might also prefer to restrict the rotation among two or three firms of their choice.

India should not jump to accept the recommendation of the IOSCO

International Organization of Securities Commissions (IOSCO) has recommended establishment of an independent regulator to oversee the auditing profession. India should not jump to accept the recommendation of the IOSCO. Some research findings observe that PCAOB’s inspections have not yielded better results than those from the peer review system.

It is not a great idea to introduce all the systems at a time without evaluating the experience of other countries. Rather, the accounting profession and the government should work together to strengthen the existing ‘audit oversight’ systems.

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