Why Not Abolish Farcical Company Audits?

Why does the law require companies to appoint auditors? To ensure that accurate, transparent information about the company is available to shareholders. But in practice businessmen cook their books with a flair that puts Taj Hotel chefs to shame, and auditors do little more than enter a few caveats in small print. This does not protect shareholders, it institutionalises their being taken for a ride.

Minority shareholders are painfully aware that audited accounts are often fiction rather than fact. Indeed, companies like Infosys and Wipro are lionised for not cooking their books, for actually telling the truth. This contrasts with traditional Indian companies who are guilty of what is politely called poor governance, and should impolitely be called swindling and lying. Some people blame Indian auditors for being too weak- kneed and corrupt to stand up to pressure from the companies they audit. When foreign auditing companies like Arthur Andersen entered India after liberalisation, they claimed with a patronising smile that they would usher in high standards.

However, the scandal-tinged collapse of Enron in the US looks like causing a scandal-tinged collapse of its auditor, Arthur Andersen. US lawmakers and investors are crying out for tougher audit rules.

Enron, the seventh biggest company in the world, went from high esteem to bankruptcy between October and December 2002. It had accumulated huge debts, but kept these off its books in order to create a fiction of ever-rising profits. Enron pioneered gas markets, and became the world’s biggest gas trader. But then it wanted to start trading in various other things including water and broadband. These investments turned sour, and so did big projects like Dabhol in India. Then natural gas prices collapsed, and trading profits slumped. Suddenly Enron lacked the cash to service its huge debts, lenders insisted on fresh collateral which the company could not provide, and so it went from hero to zero in months. Stunned shareholders, including employees, asked how the seventh biggest company in the world could go bust without warning.

Not in a single quarter had Enron declared a loss! Indeed, investment companies like Goldman Sachs recommended it as a strong buy till the very last minute. Surely Arthur Andersen should have detected and warned shareholders about overstated profits and understated debts. It did not. Was this incompetence or collusion? Arthur Andersen is one of the big five companies that dominate world auditing, and can hardly plead incompetence. It has fired a senior partner for shredding papers relating to Enron, but this looks like a clumsy attempt to distance itself from Enron.

Anyway, the real issue is not what was shredded, but what was certified by the auditors for so many years. Whether Arthur Andersen or Enron actually broke the law remains to be established by investigations. What is clear is that audit rules are loose enough to hide a pile of skeletons in the cupboard. Audits certify a company’s accounts, yet the auditor has no legal responsibility for ensuring clean accounts, nor even legal powers to force a reluctant company to reveal all.

The process is one of self-regulation. Supposedly decent companies appoint supposedly decent auditors to produce supposedly decent accounts. Notwithstanding occasional outrages like Enron, this self-regulatory system has so far worked tolerably well in the US, where fear of prosecution deters open fraud. But in India, the slow legal process ensures that crooks die of old age before being jailed (look at Harshad Mehta). In such a milieu, self-regulation by companies and auditors is pure theatre, both tragedy and farce.

Arthur Andersen was both an auditor and a management consultant to Enron. This meant a conflict of interests. If you are earning millions of dollars in consultancy fees from a company, will you really do a hard- nosed audit of its books? You might be sacked, losing both your audit and consultancy fees. A move is now afoot in the US to ban auditors from offering audit and consultancy services to the same customer. Yet this reform ignores the most serious of all conflicts of interest. This is that the company management, whose probity is be to certified, can appoint and sack the auditor. This is rather like allowing every thief to appoint the judge in his case, and sack any judge who delivers inconvenient verdicts. Outrageous.

India needs new audit rules. First, an independent regulator should oversee auditors, inquire into dubious audits, and disqualify auditors in the worst cases. Second, auditors must be given legal powers to demand key documents, and the legal obligation to participate in the prosecution of companies that fail to produce such documents. Third, minority shareholders rather than managements, should appoint auditors. These are just a few ideas, and we need a national debate on audit reforms. Some will suggest government audits for all companies, and possibly nationalisation of auditors. But an unsackable army of government auditors will surely prove as corrupt as the customs or income-tax authorities.

Competition is always a better way of inducing good performance than inspectors. We need to devise an audit system that penalises the crooked and rewards the honest. I do not claim to have all the answers. The accountancy profession needs to come up with workable ideas for reforms. If it does not, surely we should consider abolishing compulsory audit altogether. Honest companies will still produce honest balance sheets and dishonest companies cooked ones. The situation will not be very different from today’s, yet will avoid much hassle, expense and hypocrisy.

That is not ideal, of course. Ideally, we should have an honest accounting system. But better than a hopelessly dishonest system is no system at all. My father was a chartered accountant, and I do not lightly propose abolishing the profession. But I do think the threat of extinction may help energise the profession to come up with new proposals that restore the link between accounts and accountability.

What do you think?