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Auditors are likely to become extremely conservative, risk averse and short-term focused in their relationship with clients.
The biggest changes in audit regulations worldwide have often been in response to major accounting scams. The Companies Bill 2012 is no exception. The proposed changes discussed below have the potential to bring a tectonic shift in the audit profession; both in its structure as well as auditor behaviour.
Mandatory rotation: For the first time in India, periodic rotation of audit firms is now mandated for all listed companies. Audit firms now have a maximum tenure of 10 years, and a three-year period to comply with the new requirements. It also empowers shareholders to determine the frequency for rotation of audit partner and team.
Rotation has been introduced, together with a five-year term to provide tenure protection and shield auditors from dismissal after completion of any given year's audit and prevent replacement without good cause. Whether this objective is achieved remains to be seen. Perhaps an approval from the Central Government or SEBI, instead of annual ratification by shareholders, would serve the objective better.
Limits: A limit of 20 audits per partner, without any distinction between public and private companies, as against the current ICAI imposed limit of 30 audits. This significantly reduces the amount of work a firm can take on and does not take into account the size and complexity of the audit as well as the capabilities within the audit firm. In addition, the limit of 20 partners per partnership imposed by the Partnership Act makes this a 'double whammy', unless long-pending hurdles are cleared for firms to convert to LLPs (limited liability partnership).
Other services: The auditor is prohibited from providing several non-audit services to the audit client or its holding or any subsidiary companies including investment advisory, investment banking and management services. This is wide open to interpretation and may limit auditors from providing services that do not pose any risk to independence. As a result, if any prohibited services are provided even to an immaterial entity in a group, the audit firm could be precluded from auditing any entity within the group.
Penalties: For contravention of duties, an auditor is liable (including unlimited personal liability in some situations) to pay damages to the company or 'any other person' for losses arising from incorrect or misleading statements in the audit report or for misleading statements in a prospectus. Further, the firm and the partners are jointly and severally liable (whether civil or criminal) for any fraudulent actions of even a single partner.
Class action suits, a new concept introduced by the Bill, can be filed against auditors to claim damages or compensation or demand any other suitable action for improper or misleading statement of particulars in the audit report or for fraudulent, unlawful or wrongful actions.
In all these provisions, there doesn't appear to be any concept of proportionality or linkage between the potential liability and the auditors' involvement.
Whistleblower: The auditor should immediately inform the Central Government if she/he has reason to believe a fraud has been committed against the company by its officers or employees. There is no clarity on whether only material frauds are to be reported or even an embezzlement by a rogue employee.
Reporting: For all companies, an auditor is required to comment on the adequacy of the internal financial controls and their effectiveness, including orderly conduct of the company's business. These requirements are more onerous than those under the Sarbanes Oxley Act, and need to be proportionate to the extent of public interest in companies, perhaps based on market capitalisation or some such metric.

The flip side

While these changes are steps in the right direction, there can be other unintended consequences. With rotation, we will move from a state where auditor changes are uncommon to one where the changes are frequent due to low tolerance level between auditor and company. There is bound to be concentration of more work towards the largest firms, which is not a bad objective as we are, perhaps, the only country where nearly 1,200 audit firms serve at least one public interest entity.
As the scope of auditor services is restricted and reporting responsibilities have been significantly enhanced, auditors are likely to become extremely conservative, risk averse and short-term focused in their relationships with clients. Auditors will be answerable not just to shareholders and regulators, but also a wide range of stakeholders, leading to increased professional scepticism.
While auditors found guilty should be penalised, the current provisions are vague and subject to wide interpretations. Accordingly, the risk associated with audits increases significantly, severely impacting the cost of professional indemnity insurance and, hence, audit fees. To make auditors more accountable, there is need for greater monitoring rather than additional penalties. The latter has the unintended consequence of making the profession less attractive to newcomers.
Sai Venkateshwaran is Partner and Practice Leader, Financial Reporting Advisory Services, Grant Thornton India LLP