Auditing and public oversight

As per latest reckoning nearly 150 Indian companies, audited by as many as 91 auditors, have their debt or equity listed on exchanges in Europe. Most countries in Europe, currently 27, form what is called the European Union (EU).

The EU promotes a single market among its member states through law and regulation which now, through the EU’s Statutory Audit Directive (8th Directive), includes the audit profession. Once implemented by the EU member states, the 8th Directive could mean that Indian firms which audit non-EU companies listed on stock exchanges in any of the EU member states, may have to face local EU regulatory oversight.

All audit firms outside the EU, whose clients are listed on regulated exchanges in the EU (as public interest entities), may be required to register with the local audit regulator in the EU member state where the client’s shares are listed.

If the firm has to register, the relevant regulators will then be required to oversee these firms and subject them to the local Quality Control and systems of investigation and penalties, in the relevant member states where the clients are listed.

A fundamental consideration for deciding whether registration is required is the evaluation of the Public Oversight System (POS) in the audit firm’s country of origin.

One of the requirements that will enable the Indian POS to achieve “equivalence” and reciprocity will be the execution of its governance by non-practitioners.

At the most, a minority of practitioners can be involved in the governance of the POS. These may be specialists who have never been linked with the audit profession or former practitioners. By definition, a non-practitioner should not have been associated with an audit firm or carried out audits for at least three years before his involvement with the Oversight system.

In contrast, in India, the Institute of Chartered Accountants of India (ICAI) has historically had an overwhelming majority of practitioners on its governing body. This single fact may become the highest hurdle for evaluating the adequacy of Oversight on Auditors by external regulators.

This independent POS, as per the 8th Directive, should have the ultimate responsibility for the oversight of approval and registration of statutory auditors and audit firms; adoption of standards of professional ethics; internal quality control of audit firms and auditing; continuing education; quality assurance; investigation and disciplinary systems. Nearly all of these today are exclusively the prerogative of the ICAI. Does this indicate a major shift in the role and function of ICAI, a few years down the line?

In addition to evaluating the effectiveness of the POS, the local EU regulators in the relevant member states will separately evaluate the effectiveness of the quality assurance system (Peer Review) in the country.

While we would struggle to satisfy a number of the above considerations, on the last point above, the ICAI has very consciously and by public announcement totally de-linked the Peer Review system from any disciplinary consequences. Therefore, for both Independent Oversight and the matter of “consequence management”, the quality assurance system in the country would have to be restructured to meet EU Standards.

The 8th Directive also requires the presence of an effective system of investigation and penalties, as well as providing for effective proportionate and dissuasive penalties on audit firms for inadequate execution.

Last but not the least, the EU requires audit firms, which have clients listed on an EU-regulated exchange, to produce an annual Transparency Report. These reports have to be published on the auditors’ respective websites and include information about the firm such as a description of its legal structure; ownership; network, governance structure, internal Quality Control system and a declaration by the management on the effectiveness of its quality control processes.

Auditors are required to display information that indicates when the firm was last subject to an external quality review; a list of all public interested entities audited by the firm; a statement of the firm’s independence practice and confirmation of internal review of independence compliance and a statement of the Continuing Professional Education Policy followed by the firm.

The 8th Directive has to be implemented by all EU member states by June 2008. The countdown has already begun.

This article appeared in the 14 December 2007 edition of Business Standard, which is available at this link.

The convergence to IFRS

In the history of civilisation, a time comes when an idea, a thought, or a concept catches the fancy of masses and spreads across the globe rapidly. Since 2005, we have been living in the midst of such a contagion — the relentless march of IFRS, the International Financial Reporting Standards.

IFRS, in its present form, was implemented in January, 2005. Today, the EU, Australia, Hong Kong, China and the West Asia require publicly listed companies to be IFRS compliant. More than 100 countries mandate or permit IFRS, which is now rapidly becoming the common language of business.

The last bastion, the United States, has indicated acceptance of IFRS without reconciliation to US GAAP for foreign fillers by 2009 and is also considering usage of IFRS by US companies.

Today, it is no longer a question of ‘Should India convert to IFRS?’. But rather, a question of ‘By when would India fully convert to IFRS?’. The ICAI has tried to answer this with a Convergence Declaration for all Public Interest Entities from 1st April 2011 and that will be extended to other entities in a phased manner.

The Convergence declaration is a noble intention but its implications have not really been understood. A convergence by 1st April 2011 actually means that comparatives from 1st April 2010 have to necessarily be IFRS compliant; which in turn means that by the end of 2009-10 companies should have an IFRS closing Balance Sheet.

To enable Convergence, a large number of Acts require to be amended. For starters, the Companies Act, 1956 and the Banking Regulation Act, 1949 and each and every Act that has any pronouncement on accounting, Presentation, Measurement and Disclosure, requires to be brought in line with IFRS requirements, or better still, all provisions in the various Acts require to be jettisoned.

With IFRS, basic definitions will change. Preference Equity would become Loans; Dividends would become Interest; Hedge Accounting would arrive in all its glory and complexity; Embedded Derivatives would be discovered, prised out and valued; Business Combinations would be accounted for on fair-value Basis, unlike historical costs under Indian GAAP.

Further, companies would have to redefine their key performance indicators and redefine their distributable profits. Banks and lending institutions would require re-contracting covenants and milestones. Managerial and other remuneration and compensation benchmarks would have to be re-designed and IT & MIS systems would have to be re-designed to capture newly required information.

While revenue authorities would have to be re-oriented on the change in the basic accounting framework, Markets, Investors and Analysts would have to re-skill themselves.

The entire panoply of the Accounting Standards Board of ICAI, the National Advisory Committee on Accounting Standards (NACAS), SEBI’s Committee on Disclosure and Accounting Standards (SCODA), RBI’s pronouncements on revenue recognition, valuation etc. would have to be dismantled.

Companies in India have, of late, frequently resorted to the strategy of forwarding detailed schemes of accounting entries, which are not necessarily Indian GAAP compliant, to obtain a favourable judicial dispensation. Indian GAAP defers to judicial pronouncements on accounting matters, even though the recommended position might not be as per accounting standards.

This is because the preface to Accounting Standards itself states that legislative/judicial pronouncements are of higher hierarchy. However, this does not work in an IFRS scenario and any judicial pronouncement at variance with an IFRS pronouncement would render accounts non-IFRS compliant.

It is a matter of great concern that India’s name does not figure on the list of more than 100 countries who have embraced IFRS. We have only made statements of intention to converge without having seriously thought through the issues, whereas an already IFRS compliant China would be laughing all the way to the bank!

This article appeared in the 03 December 2007 edition of Business Standard, which is available at this link.