Globally we have witnessed quite a few large accounting frauds, Enron, WorldCom, and Satyam closer to us. These have resulted in shareholder value erosion and loss of investors’ confidence. Pursuant to this many steps were taken to avert such situations. Mandatory rotation of auditors was one such measure used to end the cosy relationship a company shares with its auditors. In India, the Companies Act, 2013 – which came into effect on 1 April 2014 – makes it mandatory for companies to rotate their auditors every few years. So, is this measure enough to curtail frauds? And does effective corporate governance means good corporate performance?
To answer these and more, Rakesh Rao interacts with Antonio Marra, Professor of Accounting, Control and Real Estate Finance at SDA Bocconi, Italy – one of the countries where rotation of auditors after a fixed tenure is a mandatory. Associated with SDA Bocconi since 2008 as full time faculty, Prof. Marra’s research interests include links between corporate governance and firm performance, earnings management, and auditing & related issues.
Prof. Marra, who has worked as consultant in auditing firms before beginning his career in the academia, believes mandatory auditor rotation is effective, but it is not the only solution to prevent accounting frauds. According to him, regulatory framework has to be in sync with the time and help regulators identify frauds and take preventive steps.
Which are the emerging trends that are shaping the auditing industry?
Though auditing industry is resistant to changes, three trends are quite evident. First, IT tools are being widely used in the auditing processes. Second, firms are focusing on specialisation in terms of practices (experts in accounting standards) or sector-wise. Third, they are increasing the number of offices in multiple locations to be closer to the clients.
How has the accounting standards evolved post financial crisis of 2008?
The approach of regulators, not just in the accounting industry but in general, is more often reactive rather than being proactive. Changes take place in the regulatory framework more as a response to an event. In respect to accounting, it can be said that standards have not kept pace with the evolution in the economy.
Looked at it in isolation, the changes in accounting standards between 2008 and today seem extensive. The key question though is, are these enough? To site an example, globally, in spite of all the modifications and improved standards, there are still several financial instruments in accompany which are not properly managed by accounting standards. The economy obviously is evolving much faster than the norms laid down by the regulators.
Regulators, it appears to me are quite often detached from the market, this could be a key reason why accounting standards have failed to keep pace with the trends in the real economy.
Having said that, there are countries where the entire accounting world has transformed after 2008. For example, all countries in Europe have shifted from local GAAP (Generally Accepted Accounting Principles) to IFR (International Financial Reporting) standards. Considering the approach to accounting in IFR is distinct from the traditional cost-based GAAP standards, shift to IFR is quite radical and implies large changes in culture, organisation and financial market functioning. This is something new, and is being adopted by many organizations across the globe. Even India is moving towards IFR standards.
Has the reaction of the regulators to 2008 financial crisis been different to that of pre-2008 accounting scandals (such as Enron, etc)?
The 2002 fraud was related to one company and its implication was restricted to a few companies. Hence, it was easy to identify the problem and fix it. The 2008 financial crisis impacted banks, financial institutions (FIs), Companies amongst others which in turn had an impact on the GDPs of large economies. Hence, it is taking a longer time to understand and find solutions to these problems because we are not in a position to fathom the extent of involvement of these organisations in the crisis and its implication on the global economy.
Have the changes in accounting standards opened up new growth avenues for auditing firms?
The sparkling market has indeed helped auditing firms to improve their financial performances as it has opened up new areas of opportunities, which was not earlier available to them. Enactment of Sarbanes-Oxley Act of 2002 (SOX Act) in the US, rise in adoption of IFR standards, etc are few of the factors driving growth of the auditing firms.
The SOX Act – enacted as a reaction to a number of major corporate and accounting frauds, including Enron and WorldCom – has raised the accounting standards for all US public company boards, management and public accounting firms. Basically, the Act forced the companies to audit their financial statements with external auditors, thus offering additional source of revenues for the auditing firm.
For companies who want to globalise and attract overseas investors, it is important (though not mandatory) for them to either adopt the two commonly used accounting standards (i.e, IFR or US GAAP) or get listed on the renowned stock exchanges such as New York, London, etc. With the number of companies adopting IFR increasing, more opportunities have emerged for auditing firms as they are much better prepared for the new assignments.
On one hand, the auditing firms are improving their revenues by offering multiple services in a complex working environment. On the other hand, in a sparkling marketing environment, their activities have become riskier.
Asset bubble was one of the major reasons for 2008 crisis. Are we better prepared for it today?
Bubbles are embedded in the modern economy because a large part of the growth is based on paper and not cash-based. So, some form of a bubble, every 20-30 years, will explode in the growing economies because of the over estimations of the future returns by individuals or organisations. But the efforts should be made (by organisations and regulators) to reduce the size of the bubble so that its impact can be controlled. Regulators need to be proactive in taking action.
Is good corporate governance equivalent to good performance for the company & its stakeholders?
Not necessarily. Good governance is a tool that can help performance get better. But, there is no proof that good governance automatically results in good performance. Historically, there have been companies known for their corporate governance, but could not last long as their performance was abysmal. It can be said that companies with good performances over a long period of time, normally also have high standards for corporate governance. However, good corporate governance alone cannot lead to increase in profitability and sales. Corporate governance can provide basic ground work (or guidelines) for creating good companies to perform over a longer period of time.
Good performance, especially in uncertain conditions, comes with good ideas and innovations, and corporate governance should facilitate these ideas to generate better performance for the company in an ethically acceptable manner.
For impartial auditing, the external auditors have to perform independently. How can one ensure auditor’s impartiality, given that the organisation (whose accounts have to be scrutinised) is, in a way, the client of the auditing firm?
In theory, an auditor’s role is to protect shareholder’s value by doing his/her job impartially, irrespective of who is paying. At present, the company hires an external auditor to check its financial statement, which some view as a conflict of interest for the auditor.
There are some countries that have adopted the rules such as compulsory rotation of auditor (or auditing firm) after fixed period of time, having two auditors from different firms, etc. however; even these systems have loop-holes.
There are two ways to ensure true independence. First, auditing firms can be made public institutions so that they are independent of market, organisations, government, etc. Second, an independent body (may be the financial market regulator) can be entrusted upon to appoint an external auditor for the company.
India’s new Companies Act, 2013 makes mandatory for companies to rotate their auditors every few years. Do you feel mandatory auditor rotation improves accounting standards?
Mandatory auditor rotation can improve financial reporting standards by reducing the chances of accounting scams. It is difficult for companies to perpetuate frauds as they have to face a new auditor after a fixed period.
But this in itself is not enough, for things to work, it is important to frame rules that are very clear (with no scope of ambiguity) and build in strong penalties for unethical behaviour.
In addition to mandatory auditor rotation, there should also be systems in place to help government, regulators, auditors, and FIs etc to detect and punish behaviours that deviate from the standards of ethical financial reporting.
According to you, is the new norm (i.e., mandatory rotation of auditors) a challenge or an opportunity for the auditing firms?
There is a conflicting evidence about this depending on the situation. Mandatory rotation represents a good opportunity for auditing firms who are not leading the market. For leaders, having a large market share in the auditing industry, it will be challenging as they can retain their clients only for a fixed period. So, the competition will hot up among the auditing firms due to the changes in auditing norms.
On the other hand, as a result, compliance cost for auditing firms will go up. Auditing firms invest heavily (time and money) in the first couple of years to understand an organisation and the complexity of its business, before they start garnering higher margins.
While new Act will offer opportunities for new auditors, it will also have an effect on the profitability of the auditing firms.
Has there been a rise in accounting frauds globally of late?
Large-scale accounting frauds have decreased in the last few decades; primarily due to stringent regulations. However, the nature of frauds has been changing. Organisations are adopting new means for unethical reporting or perpetuating small frauds (which are too small to be detected by the regulator or the auditors) they are carrying these out from multiple locations. Such kind of new frauds and their size are often difficult to detect.
In the last few years there has been an increase in clashes between employees and top management. How can companies reduce these conflicts?
There are a lot of disparities in the remunerations terms of employees and that of the top management. Low rate of employment and slow growth rate are leading to unrest in some parts of the world. Corporates are aware of it, but have hardly taken any steps to solve these issues as they believe these are irrelevant for them. The modern economy should ideally find a way to reduce wage differences between blue-collared workers and top management as it can lead to a friction resulting in a large conflict in the long run.
When the difference in compensations for the employees and top management becomes too large, it is not good for the organisation, in particular, and the economy, in general. Sharing a part of the fortune with the employees when the organisation’s performance is good and making them part of the decision-making processes can go a long way in reducing these disparities.