In the US, where market intermediaries immediately experience the consequences of scandal and regulatory sanctions, Arthur Andersen, the big daddy among audit firms is in serious trouble.
Apart from the $750 million that it has offered in settlement of Enron related litigation, Andersen is facing an exodus of its big clients. Delta, Ford Motor Company, Freddie Mac and Merck are among the first to give it the sack and a few others may follow their lead.
The Enron failure exposed how cozy linkages between companies, their auditors (also doubling as consultants) and lawyers escaped multiple supervisory systems and astute analysts - this has unnerved investors around the world.
The Enron burnout is expected to trigger statutory changes across the world on par with those that followed the great crash of 1929. And it is only appropriate that India begins to focus on supervision of audit firms without waiting for a huge accounting scam to force change. In fact, the move to introduced systemic changes has already begun.
The Department of Company Affairs is in the process of putting together a comprehensive regulatory framework for auditors. For starters, it has identified four broad focus areas - first, it plans to set up a committee to overhaul accounting rules and make them binding on all audit firms.
These are aimed at improving accountability and empowering auditors' vis-à-vis companies who pay their fees.
The DCA's second proposal is to make heavily qualified accounts unacceptable, and initiate disciplinary action against companies that are brazenly fudging their books. Hopefully, this will ensure that managements is not allowed to gloss over the auditors' qualifications with airy explanatory notes that leave the investor completely confused. Instead, DCA plans to force companies to present fair and unambiguous accounts.
Lynn E Turner, a former SEC chief accountant told The Washington Post that "financial fraud and the accompanying restatement of financial statements have cost investors over $100 billion in the last half-dozen or so years".
In India, there has been no attempt to quantify the cost of financial fraud, but one can safely assume that it is significant. All we have is the example of the CRB Group, which collapsed like a pack of cards in the late 1990s. CRB had built up a Rs 10 billion conglomerate offering financial services, market intermediation and a mutual fund.
The group was essentially running a Ponzi operation that was based on fudged accounts, which managed to dupe the credit rating agencies as well. Hopefully better balance sheets will prevent another CRB from happening.
But disclosures alone may not cover auditors who fail to qualify accounts in the first place. The DCA needs to fix this problem by making it obligatory for auditors to report violations by companies to the authorities.
This will ensure that auditors cannot simply walk away from shady clients by resigning an account - they will have to report legal transgressions to the authorities.
A third idea is to initiate a debate on non-audit and consultancy services offered by audit firms.
The audit community itself realises that some restrictions on their consultancy business are unavoidable. They have come up with their own suggestions for self-regulation such as a cap on non-audit services or a mere disclosure of consultancy fees earned by them in the annual report.
Is this enough? Or is it better to move towards a more permanent solution such as disallowing audit firms from offering consultancy services to the same client?
This issue is being debated around the world, where the overwhelming global opinion favours new rules. It will be interesting to see what regulatory actions are initiated elsewhere.
Finally, the DCA wants to take direct charge of supervision of auditors instead of leaving it to the benevolent self-regulation by the Institute of Chartered Accountants of India.
Unlike the US where the SEC regulates auditors, the Indian structure has the DCA in charge of their supervision. This has inherent weaknesses.
First, the DCA's record of supervision is rather patchy and since it is not directly connected with investor protection, it faces less pressure from investors. This too is changing. Investor groups are already drawing the DCA's attention to auditors' lapses.
The Kanpur based Midas Touch Investor Investors' Association has written to the DCA demanding that it investigate auditors of 229 companies that have been identified as having 'vanished' with investors' funds in the post 1993 IPO mania.
Midas says that in many cases, auditors failed to compel companies report misutilisation of funds in the annual report as is required under various rules. It has submitted a detailed list of auditors of all these companies along with their addresses in order to facilitate the investigation.
Interestingly, the one issue that the DCA has failed to touch upon in its proposed plans is financial penalties. US commentators' say that regulatory sanctions and controversy are usually an adequate deterrent - some one even described SEC sanctions as a death knell for the audit business.
The exodus of Arthur Andersen's top clients suggests that this may be true of the US, but we have seen no sign of it in India. Apart from losing clients, top US auditors have forked out sums running into several hundred million dollars to settle investor litigation against them for audit failures.
The SEC too has sanctioned as many as 280 auditors from 1990 alone, but in most cases, the matter is settled with the payment of a huge fine and no admission of guilt. The fine is usually large enough to act as a deterrent.
In the Indian context, litigation is meaningless because of the tortuously slow judicial system. Also, courts have never handed out exemplary damages in economic offences that would have made the long litigation worthwhile.
We need to find other ways to impose a steep cost on audit firms for failing to perform their fiduciary functions. We also need a debate on the issue of introducing multiple deterrents such as monetary penalties, revocation of licenses, peer pressure and a ban on conducting important audits such as those of government departments and banks.
Finally, new regulations will work only if the regulator wants it to. The US example proves that several complementary layers of supervision and review do had also failed because of poor coordination.
The DCA's new accounting rules will only be effective if it acts swiftly and credibly, so that its sanctions and punishments strike hard at future business opportunities of audit firms if they collude with unscrupulous managements.