Sucheta Dalal :Time we debate issue of regulating auditors (4 February 2002)
Sucheta Dalal

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Time we debate issue of regulating auditors (4 February 2002)  

After the savage destruction caused by Enron, journalists and analysts are scouring the rulebooks for accounting fiddles that US companies could be hiding and the loopholes that let them and their auditors off the hook. Their findings are scary enough to keep conservative investors away from the US capital market. The nervousness is palpable—just the rumour that several large companies were planning to restate their accounts had sent stock prices into a tailspin last week.

And yet, US companies and auditors are far more regulated than in India with several complementary layers of review. The American Institute of Certified Public Accountants is similar to the Institute of Chartered Accountants of India in protecting its own. It lobbies for its members but rarely punishes them. But there are other regulatory controls over auditors. The Securities Exchange Commission can bar auditors from auditing publicly traded companies for unprofessional conduct. The Indian system blissfully believes that ICAI’s self-regulation is adequate. The Securities and Exchange Board of India has no powers whatsoever over auditors and the Department of Company Affairs, has rarely exerted itself.

The US system also gives state regulators the power to take away an accountant’s licence—which not an uncommon occurrence. Yet, David S Hilzenrath in his extensive analysis of the auditing profession says that The Washington Post’s analysis of “hundreds of disciplinary cases since 1990 found that when things go wrong, accountants face little accountability” despite the multiple layers of review.

An Andersen study (ironically enough!) showed that as many as 233 companies retracted and corrected corporate accounts in the last three years including Xerox Corporation, Cendant Corporation, Waste Management, Sunbeam and Mercury Finance. Many top accounting firms also paid hefty fines for failing to do their job. Yet there are enough loopholes to make their rule book porous. Lynn E Turner, a former chief accountant at the SEC had estimated that “financial fraud and the accompanying restatement of financial statements have cost investors over $100 billion in the last half-dozen or so years”. Yet the generally accepted accounting principles of the US is considered the global gold standard. Perhaps this is a good time for us to follow the US debate over auditors’ responsibilities and put in supervisory structures and plug loopholes in our system too.

Paul Krugman, writing in The New York Times lists the reporting of employee stock options by companies and top management compensation as two elements that induce companies to go for aggressive accounting practices to drive up stock prices. He quotes Robert Shiller’s book “Irrational Exuberance” which says that a rising market is like a natural Ponzi scheme, in which each successive wave of investors generates gains for the last wave, making everything look great until you run out of suckers. Such an environment, says Krugman, makes it “easy to run deliberate pyramid schemes. When the public believes in magic, it’s springtime for charlatans”.

The two huge financial scams in India over the last 10 years were based on exactly this kind of “operator” driven magic. If the late Harshad Mehta aspired to be the Pied Piper, so did Ketan Parekh. They did not even have to ask companies to cook up their books— planting good news stories about expansion plans and export orders were enough to drive up prices. Public disclosures were orchestrated through carefully timed leaks to the media. But is the role of corporate houses in the scam being questioned? No. The Joint Parliamentary Committee of 1992 had let off industrialists with some desultory remarks while JPC 2001 had done even better — it has decided not even to call the most notorious of Ketan Parekh’s cronies for interrogation. The question is, can Indian investors rely on audit statements and where should the debate begin? For instance, should we start with who pays the auditor? Way back in 1999, investment wizard Warren E Buffet quoted the proverb:”whose bread I eat, his song I sing” to describe auditors. He said that although “auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.”

The US Supreme Court corrected this problem when it ruled in 1984 that auditors have an overriding duty to protect the public interest. While asking auditors to be ‘public watchdogs’ the courts also made the distinction between watchdogs and bloodhounds and ruled that the latter function was not expected of auditors. Yet, the number of times that accounts are corrected indicates that they find the responsibility very onerous. Fortunately for them, the Private Securities Litigation Reform Act has made it extremely difficult to sue auditors and let them off the hook. We have a similar situation. Let alone auditors, it is extremely difficult to sue anybody without deep pockets and years of patience. Worse, there is never a frank debate by the auditing profession or the regulators on specific auditing lapses such as Tata Finance, the CRB group etc. Even when a limited review of accounts by DSQ Software throws up serious mis-statements in the accounts, all it attracts is a snigger — since no major investor is interested in the stock anymore. In fact, if the regulators and government had paid attention to the extensive auditor’s qualifications of Unit Trust of India’s accounts over the last 10 years, they would have been alarmed enough to order regulatory supervision for the Trust.

Instead of pushing for change, DCA permits ICAI to be the sole arbiter of professional conduct of auditors without any regulatory supervision of the self-regulatory body. In fact, the ICAI, which wants a role in investor education does not even have a mention of disciplinary action against its members, if any, on its website. Does anybody know whether the audit firm, which helped the CRB Group build its enormous house of cards, had its license cancelled? Clearly not. But the time has come to change the rules. However, unless retail and institutional investors demand a statute backed structure for better supervision and regulation of audit firms nothing will change.

-- Sucheta Dalal