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Checking, not a re-audit
January, 16th 2009

The Securities and Exchange Board of India's decision to subject all Nifty and Sensex companies to a peer review of their accounting statements, may not be a bad idea, if some pitfalls are avoided. The idea is that the working papers of the companies statutory auditors, relating to financial statements, would be reviewed by an independent panel. It should be obvious that this is a reaction to the Satyam fiasco, and the regulator wants to be seen doing its bit. In the given circumstances, such a move might well instill some confidence in the investing community about the veracity of the accounts of leading firms. It might also make statutory auditors take their responsibilities more seriously because they stand to be challenged by their peers and run the risk of losing their reputation. So Sebi may be justified in insisting that an independent auditor check whether the information collected by the companys statutory auditors does in fact reflect in their notes and review of the accounts.

However, it is not clear how this will work in practice. It would be quite extraordinary (and virtually unheard of in the world of joint stock companies) for one auditor to be sitting in judgment on anothers work. Indeed, some may be reluctant to get into not such review work because of the possibility of messy disputes; others may seize the chance to question the work of rival firms. If such situations are to be avoided, it should be clear that what is being attempted is not a re-audit but a process review. Anything beyond that could lead to more problems than solutions.

In an emerging market like Indias where there are nearly 7,000 listed companies, simply making sure that the top 50 companies are not misrepresenting their financial results is not really going to answer questions in the minds of the investor community. Anticipating this criticism, Sebi has said that the accounts of some listed companies, other than those in the Sensex and Nifty, would also be reviewed. Random sampling can help, but rather than the larger companies, it is the hundreds of mid-sized companies whose accounts need to be examined more closely-on a random sampling basis, in order to keep the task manageable. This universe is under-researched by the analyst community and largely ignored by the media. As a result, any accounting or corporate malpractice comes to light rather late in the day, and sometimes never. Many of these second-tier firms have grown rapidly in the last three or four years and it wouldn't hurt to take a second look at what auditing process has been followed.

However, even several rounds of auditing will not help unless accounting rules in the country are tightened. To start with, the authorities must ensure that companies comply with the basics; they must ensure that all companies start publishing quarterly consolidated numbers and give details of the operations of their subsidiaries, even if these are not wholly-owned. Besides, balance sheets should be complete and not delayed, unless there is a valid reason. Also, the number of items that can be directly booked in the balance sheets should be reduced. Once these rules are in place, Indian companies annual reports will become more credible documents.

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