Wednesday, July 6, 2016

Audit Committee Has to Exercise Its Power Effectively


On the backdrop of Satyam scam, the Companies Act 2013 has introduced new rules to improve audit quality and to punish auditors who will be found guilty of negligence or connivance with management in acts of omission and commission by the company. Will those be effective?
We often hear statements like the one that unethical management, with the support from unethical auditors, distorts financial information to mislead investors and other stakeholders. Those statements imply that auditors are corrupt and audit quality will improve only if auditors are penalised heavily, for example with jail terms, for audit errors. I am sure that those who deal with the auditing profession do not believe that the profession is full of corrupt individuals. There are black sheep in every profession and auditing profession is not an exception. But most auditing errors are ‘genuine errors’ and not fraud. Those are errors of judgement.
Errors of judgement arise often due to common cognitive bias similar to ‘self-serving bias’. Research and experiments in psychology have established that one unconsciously reaches conclusions that he/she desires or that serve him/her better. Therefore, when more than one interpretations of a law or situation or information is possible, one takes the interpretation that is favourable to him/her believing that he/she interprets correctly and objectively. Accounting presents number of situations when accounting principles and methods, applicable laws and regulations and information and evidence can be interpreted differently. Accounting ambiguity is evident by the fact that auditors negotiate with clients on accounting policy, methods of arriving at accounting estimates and accounting estimates. In this ambiguity, the bias comes into play. If the auditor believes that conclusions that favour the client favour him/her, he/she will unconsciously interpret laws and information in a manner that favours the client.
For business reasons, auditors have strong motivation to approve client’s financial statements, as an unfavourable report might lead to losing the client. The Companies Act stipulates that the auditor has to be appointed for a term of five years and he/she can be removed only by passing a special resolution in shareholders’ meeting and with the approval of the government. This has reduced the risk of losing the client and thus, has reduced the motivation to approve client’s financial statements.
Audit partners act as an agent of the firm in securing non-audit business from the client and therefore, there is motivation to appease the client. Companies Act 2013 by prohibiting the auditor from rendering specified non-audit services has eliminated one of the reasons for the auditor to remain in client’s good grace.
Companies Act 2013 requires listed companies and some other classes of companies to rotate the auditor effective from the financial year 2017-18. An individual cannot be appointed as an auditor for longer than a consecutive period of five years and an audit firm cannot be appointed for a period longer than a consecutive period of ten years. The cooling off period is five years, after which the individual or the firm can be reappointed as auditor. This has reduced the risk of familiarity bias, which arises from the inherent tendency of not hurting those who are known and impairs objectivity.
Above rules could not eliminate all the reasons that make the auditor believe that what favours client favours him/her.  For example, maintaining good relationship with the management might help in securing higher than reasonable fees, swapping audit with a friendly firm, as management will lend credence to the suggestion of the outgoing auditor, who could maintain good relationship, and reappointment after the cooling off period. In order to protect auditor’s independence from the management, the law has transferred the power to recommend appointment and remuneration of the auditor from the management to the audit committee and requires the audit committee to discuss audit with the auditor before the commencement of the audit, during the audit and at the end of the audit.
In practice, the audit committee does not exercise the power effectively. It approves management’s proposals for the appointment and remuneration of auditors as a routine and does not spend sufficient time in discussing audit with the auditor. There could be many reasons for the audit committee’s passive approach. For example, it is because the audit committee is not independent, as independent directors hold the position at the pleasure of the management; or the audit committee members are not conscious about the impact of their passive approach on audit independence.
Whatever might be the reasons, audit committee’s passive approach would significantly dilute the effectiveness of other audit reforms introduced by the Companies Act 2013.