“There are some frauds so well conducted that it would be a stupidity not to be deceived by them,” is an aphorism of Charles Caleb Colton, an English writer of the 18th century.
It is not wise to let this happen often and such should be reserved for the most worthy ones!
The previous three parts dealt with a small sample of the well-known cases of corporate swindle and laid out an argument that the audit failures in those cases were stark and avoidable.
Before moving on to evaluate some alternative safeguards in corporate financial reporting than put too much faith in audited accounts, some discussion on the past versus the present may be useful.
Corporate frauds are not a thing of the present times only.
Close on the heels of the country getting independence, there have been celebrated frauds like the swindling of funds by RK Dalmia in Bharat Insurance.
Dharma Teja hoodwinking the banks in the case of the Teja Shipping company, and the famous Mundhra scandal that scalped the then finance minister.
All the three mentioned were jailed, as the political system in those days was not as forgiving as the modern ones!
But the numbers then may not have been as many as the present, given the relative size of the economy then and now, and the relative growth in the participation of the private sector in the last three decades.
Since the target of this critique is the audit profession, it is necessary to look at the change in the DNA of the profession over the decades.
The auditor-client nexus is not anything new. It existed at all points in time. But there appears to be a step change in this in the current times.
In the years gone by, when a team was deputed for an audit, in the briefing, the auditor would often refer to the honesty levels of the client in not very complimentary terms and urge the team members to be fully on guard and look for possible foul play in the books of accounts.
The common refrain used to be, “Apply castor oil in the eyes and look for the elusive malpractice.” Short of saying, the client is a big crook, stay on guard and do not get fooled!
Rarely was the client or the business praised in the presence of the team members. There would be tough and abrasive conversation between the businessman and the auditor witnessed by the team!
Irrespective of the personal relationship that existed between the client and the auditor, the audit boys were made to believe that they should go all out and hunt for potential audit issues!
Whether healthy or otherwise, the audit clerks would be more than sceptical and often suspicious about the client’s intentions.
It is difficult to say if this delivered a decisively better result, but the culture in the audit field back then was not of backslapping expected of the audit group with the client’s personnel.
Nowadays, especially with the advent of the big and foreign affiliated audit firms, the emphasis is on building a strong relationship with the client at not only the level of the audit partner but all the way down.
The brief to the audit team would be, “This is a very important client of the office and we have to grow the share of the wallet there and make sure enough cross selling happens, etc.”
The audit team would be briefed that the client is a top dog in its area of business and its growth is there for everyone to see and it is a privilege to be the auditor of such a company.
With such a briefing, the mind is presold on what to look for and it is unlikely that the level of questioning and probing that audit demands will be there to poke and unearth the potential issues.
Even if the audit partner acts somewhat independently and challenges the client, the so-called account partner of the client’s business or, if it is part of a bigger group, the account partner of the group will be posted of an unfriendly and unreasonable behaviour of the audit partner and, invariably, the client would win!
Added to this is the phenomenon of audit firms decorating businesses with awards and accolades and later auditing one or the other of the companies in the group.
The cultural shift of putting the client’s interest first has definitely led to complacency in the way the audit process works.
The first step in finding an alternative pillar to audit is to realise that audit has been over-emphasised as a means for assurance.
It does not seem to deserve that, for whatever reasons.
This is not a reflection on the competency of the professionals.
Banks and lenders blindly trust the audited accounts as it easily helps to pass the burden of doing diligence onto the shoulders of someone else!
Corporate borrowers are blindly trusted with their projections, accounts, and pie in the sky projects!
Bankers are lazy to dig and ask uncomfortable questions unless the borrower is a farmer or a street vendor!
The development banks of the past era were no better in this regard as most of them had enough muck accumulated in their midst which was cleansed by merging the entity with the commercial banks created later like the ICICI Bank and the IDBI Bank.
Similarly, the credit rating agencies (CRAs) and the debenture trustees (DTs) do little direct work on the companies borrowing from the market on corporate papers. The audit reports are taken as gospel and never looked beyond.
If the banks, the CRAs and the DTs had exercised independent diligence in Dewan Housing or Reliance Home Finance—just two out of 200-odd corporate frauds—the loss to them, and the public that followed them to put their money, could have been reduced.
So it is with mutual funds (MF). The fiasco of Franklin Templeton and some other MF schemes of investing in the debt papers of highly suspect non-banking financial companies (NBFCs) and similar companies has unfortunately faded from the public mind!
The suggestion of eliminating financial audit in one fell swoop will be scoffed at as a madman’s rant! This is not suggested to avoid making this essay a comedy!
But in the importance of audit as the sole governance tool, or as a source of comfort to the outside world of the lenders and creditors, the most important constituents that need protection, more than the equity investors, needs to be watered down.
Before exploring this angle further, it is important to recognise the unhealthy concentration of audit work among a few firms in the recent decade.
As could be seen from the accompanying table that even among just 10 firms listed, the top-3 have a disproportionate share of the pie.
One can imagine the kind of dominance these firms have created in a period of about a couple of decades.
It has become a fetish among companies and their audit committees to believe that only one among the 10-odd big firms can do the audit well.
This has to be undone. The work should be more evenly distributed among a much wider segment of the profession to actually achieve multiple objectives.
Over-dependence on a few firms leading to an oligopolistic market structure invariably results in inefficiency and less accountability.
The news clipping while dated to 2019, may actually be more relevant now as the intervening years have seen, in the process of audit rotation, more and more audit concentration.
It is imperative to restrict the number of large listed company audits that can be carried out by an individual partner and in total by any firm.
All firms that belong to a single network should count as one to avoid splitting.
Another table sourced from primeinfobase.com shows a list of a few partners in some of the firms handling multiple audits of large listed enterprises.
The audit committees should impose a condition before awarding an audit then the partner cannot be involved in so many audits.
The only way to improve audit quality is to aggressively improve competition.
The goal should be to spread the audit of, say, the top 500 companies progressively more equitably across around 100 or so audit firms in the country.
This may come at a price in the short run, as some of the firms taking up the audits may initially struggle to match the expectations.
But, in a given five or ten years, they would rally around and the benefits will be there for everyone to see.
While the picture on the right shows the total partner strength of the leading audit and consultancy firms in India, it is likely the audit partner strength could be in three figures in all the firms.
No desi firm will, in years to come, get anywhere close to this or even a fraction of it.
It will be well-nigh impossible for a typical desi firm to compete with these.
Unless they are assured of adequate work, they cannot make the investment in people and technology.
Therefore, the change has to be forced through legislation, that over the next few years, at least around 30-40 firms have a similar number of audits and the figure progressively increases.
The market mechanism left to itself will only lead to more concentration.
The Western ideology of very few firms with vaunted resources and technological backbone to be reliable service providers is quite flawed.
It is reported that some of the midsize audit firms are being considered by private equity players as a viable investment opportunity.
There can be nothing more disastrous than this.
Whatever little ethics and independence are left in the profession will be lost, making them a quarry for such venture investments.
Once more firms enter the fray and start auditing bigger listed companies, the complacency in various users of the financial reports that an audit done by a big foreign-affiliated firm means higher assurance, will change.
There would be questions arising from the users as to how much to trust an audit report of a hitherto less-known firm.
This is the starting point of reforming audit: that the users don’t readily believe an audit report but start to independently look at it and maybe adopt additional checks and verification in whatever manner possible.
Especially, the banks should be shaken out of their complacency to take an audit report as the be-all and end-all in making lending decisions.
It may sound like a philosophical paradox, that for an audit to get more reliable, its user should doubt it and feel the need to question and challenge and not take it at face value!
Like in homeopathy, the principle is similia similibus curantur! To eliminate unreliability, first create some unreliability!
Most importantly, the many laidback audit committees that eat out of the auditors’ hands and do not independently challenge and question, would need to do some original work.
How such questioning will help improve the governance architecture and what additional tools can be a substitute for wholesale dependence on audit reports will be outlined in the next part.
(This is last part of a four-part series.)
You may want to read first three parts…
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)
