How RBI’s tough rules impact audit companies

The central bank’s tough new rules spell major changes in the competitive landscape for financial services audits, reports Sudipto Dey.

Irrespective of whether the Reserve Bank of India agrees to suggestions by large audit firms, banks and non-banking financial companies to defer and dilute some of its new audit rules, the competitive landscape for financial services audit is in for some churn.

On April 27, the RBI set new ground rules for financial services audit, involving commercial banks, both private and public, and NBFCs, including housing finance companies, beyond a certain threshold (Please see table: What the RBI circular says).

These plans have been brewing for some time.

Over the past couple of years, issues around auditor independence and audit firm monopolies came into sharp focus following the high-profile business failures in Infrastructure Leasing & Financial Services, Yes Bank, and Dewan Housing, when auditors failed to spot the crises.

“It is a response from the regulator along expected lines after a series of frauds and failures in banks and NBFCs — the same thing happened post Satyam with the Companies Act 2013,” said Vishesh C Chandiok, chief executive officer, Grant Thornton Bharat, an assurance, tax and advisory firm.

Even so, the large audit firms — especially the ‘Big Four’ — were surprised by the intensity of the regulator’s response and its timing.

The ‘Big Four’ — Deloitte, PricewaterhouseCoopers, KPMG, and EY — have a firm grip of the audit market for private banks and large NBFCs.

“They typically gave discounts on audit fees, and more than make up the loss by providing non-audit services to group entities of their audit client,” said a partner in a mid-sized audit firm.

RBI’s new rules of a three-year tenure, and six-year cooling off period between audit contracts, ends that practice.

Naturally, the audit firms are deeply unhappy with this rule.

Partners in large firms say a three-year tenure is insufficient to recover people and technology costs that go into building an audit practice for a global network.

“Financial sector audits are complex and it takes around two years to fully understand and streamline audit practices in a large bank or NBFC,” said the audit head of one of the ‘Big Four’ network firms.

“And it is simply not worth it if I have to sit out for six years before hoping to get the client back. I would prefer deploying my audit resources and manpower talent to other global opportunities,” he added.

The cap on the number of audits and the restrictions on offering non-audit services to other group companies in the audited entity adds salt to the injury.

The issue of mandatory joint audits in entities beyond a certain threshold also makes the ‘Big Four’ see red.

Joint audit involves sharing the audit assignment between two or more firms, with the hope of improving the critical gaze on financials of the audited entity.

Most public sector banks have joint audits. But the jury is still out on whether the practice has any positive impact on audit quality.

“Joint audits drive the costs up for clients without visible, quantifiable benefits,” is a common refrain by ‘Big Four’ against the practice.

Chandiok thought the new rules may cause some firms to exit the audit market for banks and NBFCs, and focus their energies on non-audit business.

This churn, Amarjit Chopra, a veteran auditor, and former president of Institute of Chartered Accountants of India, predicted, would open up the audit market to greater competition.

Experts said audits will now be distributed among a larger number of mid- and small firms.

To make the most of the new opportunities, however, these audit firms would have to scale up by investing in people and technology and, perhaps acquire other firms.

“Size of audit firms have to become bigger, commensurate with the size of businesses they audit,” said Chopra.

To be sure, there are many mid-tier firms that can ride the new opportunity.

“This change would give even more impetus to capability development,” said Anurag Singhi, partner at Singhi & Co. But benefits from investment in manpower and technology may take two or three years to manifest themselves.

Cause: What the RBI Circular says

• Mandatory rotation of statutory auditors every three years in commercial banks (including public sector banks), and NBFCs (including housing finance companies) with total assets above Rs 1,000 crore (Rs 10 billion), followed by a six-year cool-off period.
• Banks, NBFCs with total assets off Rs 15,000 crore (Rs 150 billion), or above, need to appoint joint auditors.
• Significant restrictions on audit and non-audit services that an auditor can provide to group companies of the audited entity.
• Cap on number of audits — an auditor can audit four banks.
• Rules applicable from FY22.

Effects: How the new rules impact the audit market

• Audit firms that are part of the ‘Big Four’ global audit networks would be ineligible to continue.
• Stricter independence rules would curtail non-audit business of audit firms.
• Large banks and NBFCs have to scurry to find ‘quality’ auditors, leading to demand-supply mismatch, at least in the short-term.
• Focus shifts to ‘non-Big Four’ mid-sized audit firms to fill in the gap.
• Consolidation expected among small and mid-sized audit firms to gain scale, with fresh investment in people and technology.
• With reduced audit footprint, ‘Big Four’ expected to focus on non-audit and consultancy business.

For some of the large audit firms with a significant number of partners with financial services audit experience, the new guidelines may well encourage them to break up to optimise business opportunities, said Shailesh Haribhakti, a director on the board of several large, well-known corporations.

On the other hand, smaller firms may prefer to consolidate their operations among themselves to meet threshold eligibility criteria for audits.

Despite the consolidation the audit market is likely to remain fragmented, experts said.

“The multiple criteria of a truncated tenure of three years, long cooling period of six years, and requirement for joint audits for large entities means that there will be a constant state of transition of auditors,” says Haribhakti.

One of the fallouts of the flux in the audit market — largely stemming from the uncertainty over continuity — is its adverse impact on audit quality, at least in the short term.

Also, with most existing auditors rotated out due to the new rules, experts expect most banks and NBFCs to face some demand-supply mismatch in the short term.

“Large banks and NBFCs are likely to struggle to find audit firms that will be eligible for appointment,” Haribhakti pointed out.

The risk of maintaining audit quality will be a concern facing most boards, with its potential impact on systemic risk.

Some boards may prefer a parallel audit by a large firm to allay such fears but this would add to a company’s compliance costs.

The RBI is likely to come out with more clarifications on the new audit rules — and may even postpone its roll-out by a year as the industry has demanded — the fact remains that financial services audit business is in for long-lasting change.

Feature Presentation: Ashish Narsale/Rediff.com

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