Auditor Independence: Go the Korean Way

Auditor independence has been a matter of much deliberation across the globe, with each country attempting its own solution to tackle the issue through tendering, rotation, joint audits, and other regulations.

Each of these solutions, while trying to address the perineal question of how an auditor can be independent when the ‘auditee’ (the Company) makes the appointment, agrees on fees with them, and decides whether it continues with an auditor or fires them, comes with its own set of acceptance and implementation issues.

The Western response to this age-old dilemma was to introduce the concept of an ‘independent’ audit committee, that would make the choice. Audit committee independence, just like that of the auditors, suffers from a perception that it can’t be seen to be independent when its members' (Non-executive Directors) appointment is made by the Company.

Interestingly, Korea seems to have found an interesting fix to this.

So what was Korea’s fix? Let me summarize it in 10 points:

Auditor independence: The Korean way

1. Securities Regulator and the Company share auditor appointment over a 9-year period
2. Company can choose an auditor of its choice for 6 years and Regulator appoints one for the remainder of 3 years (‘Periodic Designation’)
3. Regulator can ask for a change of auditor when certain prescribed circumstances exist (‘Direct Designation’)
4. Direct designation circumstances include a change of CEO more than twice in 3 years, Operating losses over 3 consecutive years, Interest cover less than 1, Audit Hours much less than standard etc.
5. Companies and Auditors are segmented into 4 categories- (1-4) and (A-D) respectively. A category auditor can audit all 1-4 category companies, but B can only audit 2-4, and so on
6. Companies' segmentation is based on Total assets and Auditors' segmentation is based on a range of metrics that include the number of qualified CPAs, percentage of audit employees in the quality control team, PI cover, etc.
7. Company can appeal if it prefers not to work with the suggested auditor for a ‘good cause’, like conflict or work with a competitor, etc.
8. CEO and Head of Quality of the Audit firm must also take responsibility for audit failures, besides Audit Partner and Team
9. Standards for appropriate audit hours for each audit are set in advance by the Regulator
10. Audit firm has transparent hourly rates of its choice based on its own operating metrics and brand position.

The proof of the success of this model is in its result. In under 5 years, I understand auditors feel more independent, commercially better rewarded, and overall valued for their role in high-quality financial reporting.

Investors and regulators have more trust in Company’s financial statements being ‘true and fair’ when signed by an auditor. And ultimately Korean companies are more attractive to capital because their numbers are more reliable.

India was ahead of the world when it introduced Mandatory Audit Firm rotation through the Companies Act 2013 in Fiscal 2018. Korea has taken it further with this Auditor Designation System from Fiscal 2019.

And whilst mandatory audit firm rotation has worked well in the Indian context, the Regulators are looking for ways to improve on it to further enhance audit quality.

Bottom Line

Perhaps the answer is to learn from the Korean system and apply it in a way that would work for India.

Indian regulators including the Securities and Exchange Board of India (SEBI), Ministry of Corporate Affairs (MCA) (the National Financial Reporting Authority (NFRA) in particular), and others should consider studying this in more detail before concluding their position about mandating joint audits which is currently in the talks.

Could a ‘direct designation’ equivalent be the answer for India but applied in a way that it’s not an auditor change, rather the Regulator appoints a ‘Joint auditor’ when certain conditions exist? Could this segmented approach increase choice for all in the audit market by reducing perception barriers, particularly for small and mid-sized practitioners?

Change is constant and it’s our responsibility to continually look for steps that enhance trust in financial reporting of listed companies if Indian capital markets are to thrive in order to create a vibrant India.

This article first appeared in ETCFO.com on 27 July 2023.