Friday, December 30, 2011

Law Street in The Economic Times (December 2011)

Dear Readers,

As this year draws to a close Zenobia Aunty wonders which way India is headed. The true worth of a democracy lies in a strong government and a strong opposition. But clearly both the sides in India are playing foul. Zenobia Aunty feels that the opposition parties clearly did not let the government function, this winter session or for that matter during the earlier monsoon session. Just as the ruling party should know how to lead, the opposition parties should know how to oppose in a responsible manner.

Thus, the Companies Bill was tabled and hastily withdrawn, the Lok Pal Bill was passed in the Lok Sabha (lower house) but could not meet muster in the Rajya Sabha (the Upper house), the standing committee led by the opposition is still sitting on the Direct Tax Code, so it could not be presented during the winter session and will not be in place for us to usher in a new Tax Code in the coming fiscal April, 1. The petty politics is just sickening.

As they say, each dark cloud has a silver lining. The Companies Bill, 2011, had called for rotation of auditors. Since it now stands withdrawn, perhaps this issue can be revisited.

For the online edition of this column in The Economic Times, click here.

The column is also pasted below.

Zenobia Aunty and I wish all our readers a joyous 2012.

Warm regards,

Playing musical chairs

• Audit rotation could be a short sighted approach

• Joint audit mechanism may ensure better quality checks

• A pragmatic well thought out view must be taken

The Companies Bill, 2011, which was tabled in the Lok Sabha and withdrawn almost immediately owing to opposition pressure, prescribed for audit rotation. Zenobia Aunty wonders whether this measure would have achieved the intended objective of greater audit independence and better shareholder protection. Hopefully, before a revised Bill is tabled in the next calendar year this issue will be revisited.

For listed companies, this Bill prescribed that an individual cannot be an auditor for more than one term of five consecutive years and it also proposed a change in the audit firm every ten years. While the above prescription was mandatory, in addition the Bill gave the leeway to companies to rotate the audit partner and audit team each year or appoint joint auditors.

The European Union (EU) has also issued a proposal for discussion calling for mandatory rotation of audit firms of listed companies and those in the financial sector, after six years with a cooling off period of four years before the audit firm can be reappointed. Joint audits, where two or more auditors or audit firms conduct the audit are not proposed to be mandatory but are implicitly encouraged by extending the period of mandatory rotation from six to nine years.

In the United States, the Public Company Accounting Oversight Board (PCAOB) has sought public comments on ways that auditor independence, objectivity and professional skepticism could be enhanced; it has not concentrated on auditor’s rotation as the only or best solution.

Zenobia Aunty decided to don a journalist’s cap and interviewed a few prominent CFOs. The tenure prescribed for an audit firm was logical and doable, rotation of auditors could bring in fresh perspectives, yet this had its own evils and was not the best measure, is the overall view.

“Rotation will only result in one-upmanship with the new audit firm wanting to prove its worth vis-à-vis the previous firm, audits will remain open and audit committee meetings will cease to be productive,” predicted one CFO. Another chimed in: “When auditors change, a Company will have to battle with differences in interpretations, disclosure requirements etc. Rotations will result in either pushing up the cost of audit higher or quality of audit lower.”

PCAOB has queried: Does payment of fees by the audit client create systematic distortion which can be dramatically reduced by audit rotation? One CFO bites the bullet: “If we really want auditor independence the fees would need to be fixed by a formula based on various parameters as opposed to being fixed by the company.”

But this could be difficult, as the audit complexities vary widely from company to company. “Thus perhaps, if independent directors and consequently the audit committee were to appoint the auditors and fix their remuneration there would be greater independence,” he adds.

Joint audits found strong favour, thus perhaps before the next Companies Bill is tabled this concept should be examined in-depth. It was felt this mechanism would also resolve the constraints, weakness and loopholes contained in the mechanism of mandatory rotation, such as increased audit costs, lack of historical knowledge of the audit client, consolidation issues for global companies, and lack of specialization at the audit firm level.

Large listed companies which have met the threshold limit (based on turnover or assets) should be mandated to have joint auditors. The audit work scope and areas should be equally divided each year and mandatorily swapped after each year, such that no single audit firm audits the same area in consecutive years. Although the audit firms need not necessarily be rotated at regular intervals, perhaps the audit partner and senior audit team members of each joint audit firm could be changed every five years. The auditors opinion would be a joint opinion of the two or more firms, thus both responsibility and liability would be joint.

“Joint auditors will, most essentially, ensure that there is an in-built quality check on the work of the audit firms. This is because each audit firm will be required to satisfy itself as to the extent and adequacy of the audit work performed by the other before issuing the joint audit opinion. A natural quality control system far better than the regulatory bodies conducting third part external checks on the quality of audit work across an audit firm, would thus exist,” concluded a CFO.

All said and done, the bottom line is that an auditor is a watch-dog and not a bloodhound. Zenobia Aunty has no straight answer on the effectiveness of audit rotation. But adds: Since time is available, in addition to India Inc’s views perhaps even the views gathered at the EU level and by the PCAOB will provide more insight into this issue.

Source of the photograph.

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