Earlier this year the Ministry of Corporate Affairs(MCA) came out with a discussion paper asking for suggestions on disallowing the same firm to offer both consultancy and audit services to a client. Though officially appointed by the shareholders, the auditor’s onboarding, their work and dismissal are effectively overseen by the management, creating a potential conflict of interest.
In today's post, we look at what was covered in the MCA's discussion paper, how the relative size of the consult fee vs audit fee could affect firm decisions, and see if the move could potentially backfire.
What were the issues covered in MCA's 7th Feb discussion paper on auditor independence?
The discussion paper discussed 5 major issues including 1. Self-interest (Hyper competitive pricing may hamper the quality of auditing) 2. Self-review (Auditing reports they made themselves) 3. Advocacy threat (Hampered objectivity and independence due to increased involvement) 4. Familiarity threat (Long-standing relationship with firm affecting the quality of work) and 5. Intimidation threat (Litigation or other threats by company against auditor).
In order to avoid such cases, suggestions like making amendments to the existing regulatory provisions, prohibiting auditors to provide non-audit services, having stringent quality review procedures within firms, rotation of audit partners, the appointment of auditors by external authorities like CAG of India have been proposed.
The importance of consultancy fees.
The cost of adding experienced auditors and modelling experts as well as investing in high-end technical resources and systems is exorbitant. As competitiveness in auditing services puts pressure on the firm’s earnings, consultancy services provide relief contributing a sizable share of the revenue for these firms. For most large audit firms, the revenue from consultancy either equals or exceeds audit revenues. Splitting the two services and disallowing audit firms to provide non-audit services must ensure that the audit business itself acts as the real backbone for the firm and not make it a loss-leader in the industry.
Could the move potentially backfire?
A clear objective of the discussion revolves also around bringing down the oligopoly of the Big 4 - PwC, EY, KPMG, Deloitte, ruling the business of consultancy and audit services. This will enable smaller, home-grown firms to develop their resources, tools, and manpower to be equipped to provide these non-audit services. While on the face of things, this does look like a compelling proposition, it may backfire as these firms struggle to reach the Big 4 level of quality standards, thus hampering the overall industry audit standards. In addition, not carrying the brand tag of Big 4, these firms will be forced to operate at lower prices but incur higher costs of development of resources and will have to strive for long to get survival in the industry.
Thus, what may seem like a move in the right direction, auditor independence may impact the business of both the big auditors, smaller growing firms as well as the clients. It will take a while to stabilize things and processes in place and ensure that level of quality work and transparency.