What should investors do when auditor of company resigns?

It’s the season of audited annual results and a spate of resignations by auditors has started hitting the headlines. “It started after Sebi’s action against PwC in the Satyam Computer case in 2018. Now, audit firms are wary of associating with companies with weak standards,” says Pranav Haldea, MD, Prime Database. They fear action by Sebi or the Ministry of Company Affairs if they certify accounts that turn out to be fraudulent later.

Going by the number of resignations, auditors continue to be wary. “After major financial crises, investigating agencies go after auditors. This happened when companies like Global Trust Bank, Satyam Computer, etc failed. The spurt of recent resignations can be attributed to the IL&FS fiasco,” says Rajesh Cheruvu, CIO, Validus Wealth Management. PwC resigned from companies like Reliance Capital, Reliance Home Finance and Eveready Industries citing “unsatisfactory response to queries” as reason.

Like companies, auditors too are under pressure thanks to improved investor awareness and public scrutiny. This has been due to increased connectivity and availability of data. Institutional investor activism is another reason. “During the past 10 years, institutional investors have become bigger and have started taking proactive action. Some have also voted against managements,” says Mihir Vora, Director and CIO, Max Life Insurance.

The introduction of the Insolvency and Bankruptcy Code (IBC) and National Company Law Tribunal (NCLT) has increased proactive action from bankers. The series of debt market defaults during the past year and the increased scrutiny on defaulting companies are keeping the pressure up on everyone, including auditors.

There are other reasons as well. For instance, BSR & Associates resigned from IL&FS Investment Managers because of “investigation by regulatory bodies”. With Sebi and MCA increasingly taking action on auditors, the national professional accounting body ICAI has also started taking action against members. Interference by the newly set up National Financial Reporting Authority has also put ICAI in a spot. For example, resignations by auditors in small cap companies Kritika Wires, Surani Steel Tubes, Cinevista, etc. are because of “disqualification by ICAI”.

Jumping ships caught in stormy seas
Wary of action by regulators, many audit firms are quitting suspect firms.
Source: nseinfobase.com; Compiled By ETIG Database. Data as on 2 July 2019; Companies with less than Rs 100 cr market cap ignored from the list.

What should investors do?
Retail investors have no control over these resignations and react to the news once it becomes public. First, they need to assess its impact—whether it is routine or negative. Stock markets usually do not react if these resignations are due to routine reasons like health issues, personal reasons, conflicts of interest, etc.

Market action was also muted when Infibeam Avenues terminated auditors for ‘leaking price sensitive information’. However, markets react negatively when resignations raise governance issues like “unsatisfactory response to queries”. For example, price of Reliance Capital and Reliance Home Finance shares fell by 32% and 33% respectively in the first week of the news of PwC quitting surfaced.

While assessing situations like these, investors should consider the ‘surprise’ element. Reliance Capital and Reliance Home Finance share prices took a big cut because the negative news came as a surprise to the markets. Resignation of auditors had no impact on the share price of IL&FS Investment Managers because the news was expected.

Though short-term reaction will depend on the surprise element, the long term reaction will be negative. “Auditor resignation is a red flag and investors need to be careful. Investors do valuation of a company on the basis of published data and if that cannot be trusted, how can investors value a company?” asks Vora. It is better for investors to exit a company where auditors have raised governance issues.

For instance, Manpasand Beverages stocks continued to fall over the long term after Deloitte Haskins & Sells resigned as auditors in May 2018 citing the management’s inability to share crucial data. While retail investors could jump out in time, most institutional investors got stuck because the trading volume in the counter dried up.

Regulators are also not taking auditor resignations lightly and asking for clear reasons. This is because some auditors are resigning without giving any specific reasons. Investors need to keep track of these developments. If the auditor of the company they have invested in resigns without giving reasons, they have to assess its impact and surprise element later.

“Resignations by auditors and independent directors will continue because Sebi and MCA keep on questioning their roles if they fail to highlight problems on time. In some cases, these agencies have asked them to refund their remuneration,” says Jaspreet Singh Arora, Director and Head of Research, Systematix Shares & Stocks.