NFRA Inspection Reveals Deficiencies in Big Four Audit Firms’ Indian Affiliates
Analysis for Layman
The National Financial Reporting Authority (NFRA) in India has conducted inspections of the Indian affiliates of the “Big Four” global accounting firms, which include EY, KPMG, Deloitte, and PwC. These inspections aimed to assess the quality of audits conducted by these firms and ensure that they adhere to international audit standards, which are designed to guarantee the accuracy, reliability, and integrity of corporate financial statements.
The NFRA reviewed various aspects of these firms’ audit processes, including their overall quality control procedures and a selection of client audits with year-ends on March 31, 2021. The inspections revealed several deficiencies across the firms, including issues related to audit documentation, auditor independence rules, fraud risk assessment, IT controls testing, and errors in verifying company revenue and asset valuations.
These findings suggest that some audits may not have thoroughly examined all the necessary financial reporting risks as required by international standards. However, the reports did not specify any significant audit failures or necessitated restatements. The firms have stated their commitment to addressing the issues identified by the NFRA.
Impact on Retail Investors
Concerns About Data Reliability
The NFRA’s findings have a direct impact on the reliability of financial statements released by publicly-traded companies that engage these audit firms to review their financial reporting. Issues such as gaps in revenue testing or inaccuracies in asset valuation assumptions can lead to incorrect profits, assets, or liabilities being reported.
For retail investors who rely on audited annual and quarterly reports to analyze stocks, these deficiencies raise concerns about the accuracy of the data essential for investment decisions. Inaccurate financial statements can distort key metrics like sales growth, net profit margins, and return on equity, potentially leading to inaccurate stock valuation estimates.
However, it’s important to note that no specific audit clients with material misstatements have been identified yet. Investors should monitor NFRA statements for any remediation actions, such as corrected or refiled reports. The audit firms insist that these issues do not indicate flawed actual audits, but the findings still undermine the presumed confidence in audited financials.
Impact on Industries
Repercussions for the Audit and Accounting Industry
The Indian audit and accounting industry, dominated by the Big Four network affiliates, may face damage to its reputation and increased pressure to improve compliance with standards. With heightened oversight by the NFRA, the entire industry can expect more scrutiny.
Listed client companies may also be affected if it turns out that their previous financial audits lacked rigor. Various sectors, including banking, insurance, energy, and infrastructure, rely on the Big Four firms for audits and may seek enhanced scrutiny of past financial statements.
Boards and management teams of these companies may question their relationships with auditors and consider seeking competitive bids in the next audit cycle. However, the significant fixed costs and specialized expertise possessed by large multinational audit firms make changing auditors a challenging process. It is likely to happen only in cases of clear negligence.
Regulators like the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) may increase monitoring of compliance with standards. Additional certification requirements related to internal controls and specific reporting items may emerge to ensure quality, raising compliance costs for both audit firms and their clients.
Long-Term Benefits & Negatives
Potential for Improved Audit Standards
On a positive note, the NFRA’s findings could lead to overall improvements in Indian audit standards as corrective and preventive actions are taken by the Big Four firms. Aligning with precise International Standards on Auditing (ISAs) could enhance the real reliability of Indian corporate financial reporting over the long term.
However, there is a risk of increased paperwork, restrictive controls, and redundant labor to ensure perfect compliance with standards, which can raise costs without clear value-added benefits. Over-engineering processes may hinder practical audit efficiency without actually enhancing the core diligence of audits. These additional costs disproportionately affect smaller firms.
Furthermore, frequent changes in rules disrupt the consistent evaluation of reporting quality trends over the years. Standards-setting can lead to excessive box-checking, eroding the dynamic risk-based judgment that is integral to true audit rigor and quality.
Short-Term Benefits & Negatives
Short-Term Volatility and Disruption
In the short term (1-3 years), the NFRA’s findings may lead to increased volatility in the stock prices of publicly-traded companies audited by the Big Four affiliates. Investor confidence in recent financial statements may waver until more clarity is provided. SEBI may issue broader guidance to reassure participants in the capital markets.
However, as specific restatements or misstatements have not been identified, price fluctuations may remain relatively contained. It will depend on communications from the audit firms affirming that the audited financial statements from the past remain fundamentally reliable. NFRA may demand the refiling of some financial reports found to have inadequate audit evidence.
Transitional challenges are expected over the next 1-2 years as major firms update internal controls, templates, and toolkits to align with tighter regulations. This process comes with significant training and internal review costs. The expansion of headcount focused on routine checklist quality assurance can dilute the concentration of experienced auditors who handle complex, judgment-intensive issues.
However, this short-term disruption could pave the way for significant long-term gains in audit credibility and investor confidence in Indian financial reporting. This is crucial for accessing the growing global capital pools.
Impact of NFRA Audit Inspection on Companies:
Potentially Impacted (Losing Confidence):
- Big Four Audit Affiliates:
- S R B C & Co. LLP (EY affiliate)
- B S R & Co. LLP (KPMG affiliate)
- Deloitte Haskins & Sells LLP
- Price Waterhouse Chartered Accountants (PwC)
- The NFRA report highlighting deficiencies in audit quality could damage their reputation and lead to loss of client trust and future audit mandates.
- Market sentiment for these companies may be negative due to concerns about regulatory sanctions, potential lawsuits, and reputational damage.
- Companies Audited by Big Four Affiliates:
- Reliance Industries Ltd.
- Tata Consultancy Services Ltd.
- HDFC Bank Ltd.
- Companies audited by the Big Four affiliates might face increased scrutiny and potential restatement of financial statements due to audit concerns.
- Market sentiment for these companies could be cautious pending clarification and resolution of any audit issues.
Potentially Benefiting (Increased Scrutiny & Transparency):
- Smaller Audit Firms:
- Grant Thornton India
- RSM Astute Consulting Pvt. Ltd.
- BDO India
- Increased focus on audit quality could benefit smaller audit firms that already have robust quality control systems in place.
- Market sentiment for these firms might be positive due to potential shift in client preference towards firms with strong audit processes.
- Independent Audit Regulators:
- Institute of Chartered Accountants of India (ICAI)
- NFRA’s assertive action in highlighting audit deficiencies could strengthen its role as an independent regulator, leading to a more transparent and accountable audit ecosystem.
- Market sentiment towards these regulators might be positive due to their increasing effectiveness in safeguarding investor interests.
Limited Direct Impact:
- The news primarily affects the Indian domestic accounting and auditing industry. However, global investors operating in India might view the NFRA’s actions positively as a sign of a stronger regulatory environment.
- Global audit firms with strong India operations (e.g., Grant Thornton International) could indirectly benefit from increased scrutiny on Big Four affiliates, potentially attracting clients seeking alternative audit solutions.
Note: These are potential impacts based on the given information. Actual outcomes may vary depending on further developments, regulatory actions, and individual company responses.
ET Bureau. “NFRA Points Out Deficiencies in Audit Affiliates of Big Four.” Economic Times. Published Dec 23, 2023.