There is an urgent need to converge accounting standards

During a conversation a decade ago with a senior regulator on the prevalence and acceptance of qualified audit reports in India, the regulator remarked “Why would a qualified audit report be considered undesirable? I would have thought a ‘qualified’ audit report would mean that the audit report or the auditee had some additional attributes, just like we speak of a ‘qualified person’. This one incident etched in my mind all that bedevils India when it comes to stakeholder’s understanding of an audit report or placing confidence thereon.

Globally, audit reports are unqualified, meaning that the auditor would without any reservation express his confidence on fairness of the financial statements. Issuance of a qualified opinion, globally, is in the rarest of rare scenarios only. However, in India, convention, practice, and business usages have combined in a manner in which a ‘qualified audit opinion’ is an extremely common occurrence.

A number of these qualifications arise because the auditor wants to play safe since the past history of regulatory action does not provide confidence of regulators appreciating the ‘materiality’ aspects of reporting. While Audit works on a framework of designing processes and finally reporting results based on materiality thresholds which are linked to the size of the entity and its results, regulators and external reviewers in India tend to stray far from such a materiality driven approach.

When confronted with an aberration which in absolute terms may look quite big but in relative materiality quite insignificant, auditors and regulators tend to give more importance to the absolute size of the item and not its relative insignificance. This is one major reason why qualifications clutter up Indian audit reports. Another type of qualification pertains to wrong or impermissible accounting. These are commonly expressed in phrases like “such and such has been accounted for in so and so manner, which is not in accordance with the Accounting Standards ‘X’ issued by ICAI,…subject to our observations, the accounts give……true and fair view…”. This is unacceptable from a global point of view.

The SEC in the United States does not accept a qualified audit report under the Securities Act of 1933. As a result, all listed entities in the United States have to necessarily correct their accounts for any qualification. However, in India we go to the other extreme where a qualification is considered to be so routine that a few years back the Companies Act was amended to require that all qualificatory comments should be separately printed in italics so as to draw the reader’s attention!

Though, the Indian Auditing Standard on reporting is modelled after the relevant International Standard, its actual implementation is quite different in India. Three points of significant difference comprise — a) the tendency to qualify immaterial items, b) the tendency to simply qualified items which in aggregate or individually would be material and in most other jurisdictions would end up in a ‘not true and fair’ opinion, and c) increasing usage of the “Matter of Emphasis” option whereby an auditor merely draws the attention of the reader to some uncertainty without qualifying his opinion. There is a possibility of this being used in cases like provisioning for disputed claims and debts, where in most jurisdictions the auditors would be expected to make a judgment call and quantify under provision.

These accepted practices of audit reporting, along with India’s unique GAAS provision relating to responsibilities of Joint Auditors — where though all the auditors sign the same set of financials, each is only responsible for the work done by himself and is not responsible for the work done by the other auditors which is contradictory to the “joint and several” responsibility concept of auditors elsewhere in the world — significantly impacts the credibility of Indian audit reports.

What is the way out? A simple answer is to require that the accounts of all Public Interest Entities would have to be restated to ensure that they are free from audit qualifications/scope limitations/matters of emphasis, disclaimers and negative comments. As an intermediary step, Corporate Law may be amended to ensure that dividend distribution can only be made out of available surplus after adjusting the impact of all audit qualifications.

While we are working towards converging with International Accounting Standards, the goal of convergence and global acceptance cannot be achieved if we do not also simultaneously converge our Auditing Standards and practices.

This article appeared in the 24 March 2008 edition of Business Standard, which is available at this link.

In search of a greater assurance

As the global economy gets more complex, groups and entities across political geographies require optimising their structural efficiency owing to numerous different regulatory and tax jurisdictions.

Financial instruments are becoming more complex, intangibles and derivatives are assuming central roles in the resultant tangle and even finance professionals are often at a loss to read and correctly interpret entity financials or forward-looking statements. The lay investor is obviously at sea.

In this maze there is an increasing demand by stakeholders for a greater transparency and assurance around financial statements. There is a growing realisation that such assurance can only be obtained by rigorous examination and certification of these accounts by a service provider whom investors can rely upon.

In this quest for greater assurance, it is inevitable that there would be concerns about the competence and integrity of the assurance provider. Both these attributes require equal emphasis.

However, in some jurisdictions like India, there is an obsession with visible and presumed indicators of ‘integrity’, very often, to the total neglect of ‘competence’. This attitude is counter productive and possibly stems from a deep-seated paranoia about collusion between management and auditors. It reflects a sub-conscious distrust of the ability of regulators to detect such collusion.

Some proponents of audit quality argue that rotation of auditors, joint audits and centralised agency-driven audit appointments are a panacea. However, most of the major instances of alleged audit inadequacies in India have traditionally happened in sectors like the banking sector, where rotation, joint audits and centralised appointments, are simultaneously practiced!

Competency-based profiling of audit firms are discouraged and archaic advertisement rules prohibit firms from showcasing their competencies. Prospective users of an audit firm’s services are thus denied full knowledge of comparative strengths, weaknesses and delivery capabilities of different firms.

Thus, the process of choosing a service provider either becomes very tedious or fall backs to a default mechanism of personal knowledge and proximity to a particular audit firm.

Effective auditing depends on an auditor’s ability to develop a detailed understanding of the auditee’s complex structures and operation. Research conducted by the American Institute of Certified Public Accountants (AICPA) in the USA, of over 400 cases of alleged audit failure, indicated that in 75 per cent cases, the auditor was performing his first or second audit of the company.

This correlates with the Bocconi Report findings that in the first year of an audit, 40 per cent more audit hours are required; audit costs are greater by 15 to 25 per cent and training period for new auditors of complex groups appear to be 2 to 3 years. Very often, in industries such as banking, insurance, telecom, sector specific knowledge is a must.

Rotation destroys the knowledge an auditor develops on specific matters related to an entity. This ultimately leads to audit firms not investing adequately in industry specialism because dis-economies of rotation or cap on number of audits do not make it feasible to do so.

In fact, any un-ethical promoter group would always encourage rotation of auditors since that would ensure that the auditors are on the learning curve continuously.

Further, these companies would even prefer a practice of joint and multiple auditors and carve out different domains of complex transactions between different auditors so that no one gets the full picture.

In addition, there is also the option to levy a cap on all other types of non-audit activities so that the auditor knows less about the detailed workings of an entity. In India, they could easily do all these with the misplaced blessings of the regulators!

For greater assurance we require a paradigm shift. Auditors' integrity should be taken for granted, but needs to be reinforced by a strong and effective system of peer review; stringent and expeditious follow up of disciplinary cases; streamlining the disciplinary provisions by eliminating outdated requirements relating to deemed advertisements and eliminating permissions required by a chartered accountant for various activities such as teaching; writing articles; participating in professional sports or growing agricultural products! We need to concentrate on fast-track decisions; wide publicity to exemplary sanctions and professional misconduct and gross negligence cases.

This article appeared in the 28 January 2008 edition of Business Standard, which is available at this link.

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.

Auditing needs to become global

European investors today regularly invest across national borders. In order to safeguard their interests, the European Commission (EC) is concerned about the regulation of non European Union (EU) audit firms and has proposed principles for such regulation in EU’s 2006, Directives on Statutory Audit.

Such measures require third-country audit firms to register in EU member states wherever and whenever their client securities are admitted for trading. There is provision for exemption from registration but EC would have to evaluate and decide on the equivalence of such third country audit oversight systems prior to granting such exemption.

On a number of issues relating to how third country audit firms can be regulated and evaluated, the EC has recently undertaken a public consultation exercise. At the outset the EC mapped the current “exposure” of EU member states to audit firms of 63 different countries and quite surprisingly India topped the global list! Out of a total of 220 audit firms in 63 countries to which European investors were exposed, India accounted for 54.

Obviously India has overnight leap-frogged to the attention of European regulators and the entire gamut of the audit profession and its regulation in India are under the scanner.

The Commission and all respondents to the survey have underlined that there has to be an assessment of the equivalence of the Public Oversight System over the audit profession in all these non-EU countries. It is being increasingly felt that EU as a whole should take an equivalence decision on a common framework rather than individual EU member states evaluate individual third-country regimes.

A majority of the respondents to the EU consultation exercise felt that focus must be accorded on countries based on a prioritisation of the criteria of “number of companies concerned”, “advanced oversight structures in place” and “major world economies”.

There have also been suggestions of adopting a risk based approach of focusing on those countries which would give rise to the greatest risk for investors, if their oversight regimes were not properly aligned to international standards. Under all the possible criteria, India would be categorised as a country that would be of the highest concern.

The oversight system in India has been largely driven by the Institute of Chartered Accountants of India (ICAI). Even today, after the constitution of an independent Quality Review Board by the Government (where ICAI has 50 per cent representation) Peer Review is an exclusive ICAI domain. For the last 57 years the disciplinary mechanism has been totally within ICAI.

It is only in the last few months that the Government has created an independent disciplinary structure, with again 50 per cent ICAI participation. While ICAI has been diligently discharging the onerous responsibilities it has been burdened with by the global standards. The regulatory regime in India in its present construct would perhaps fail the tests of the definition and expectation of “independent public oversight”.

While in theory, auditors have unlimited liability, in practice there have been no significant instances of litigation against the audit profession in India or devolution of liability on auditors, in the history of the profession. This, along with the fact that the system of peer review has just been recently initiated and has yet to ensure significant coverage and also the absence of any other significant regulatory oversight may negatively impact an equivalence study as is being proposed.

The size of our country and the fragmentation of the profession would create significant challenges to convince an external audience about the profession’s ability to deliver uniform audit quality. Delayed convergence with International Generally Accepted Auditing Standards (GAAS) and GAAP could definitely further undermine any equivalence study.

Corporate India is raring to go global. Cross border acquisitions, mergers, amalgamations, accessing capital markets in a world without boundaries, is what is spurring an economic rejuvenation of the country.

But one of the fundamentals underpinning of all of this is the reliability that developed markets can place on financial statements originating in India. That is what the EU would now be focusing on. The profession has no choice other than to immediately converge to global GAAS and GAAP; to open itself, fast, to public scrutiny.

This article appeared in the 29 October 1007 edition of Business Standard, which is available at this link.

The curious case of forex capitalisation

The government and the Institute of Chartered Accountants of India (ICAI) appear to be gearing up and pushing for all-out convergence with the global accounting standards (IFRS) within 3-4 years. And, on the other hand, our known propensity for tying ourselves up in knots, in multiple legal and regulatory contradictions, is on display like never before. A case in point is the current huge confusion about a critical item on the balance sheets of many large corporates — how to treat forex fluctuation on capital loans.

The twists and turns of the tale, in brief, are as follows:Schedule-VI of the Companies Act, 1956, is very clear. It says that in consequence of a change in the rate of exchange, if there is any increase or reduction in the liability for repayment of borrowings in foreign currency (for acquiring an asset), such increase or reduction will be added to/deducted from the cost of such fixed assets. This is the position in law which continues unchanged till date from 1966.

The ICAI published Revised Accounting Standard-11, effective from April, 2004 {AS-11 (2004)}, which had a contrary provision saying that all such exchange differences should not be adjusted to assets but taken directly to the profit & loss account.

In November, 2003, the ICAI came out with a clarification which said that till the law (Schedule-VI) was not amended, the above provision of AS-11 (2004) will not be operative. The Companies Act has not been amended till date.

However, on December 7, 2006, the Ministry of Company Affairs promulgated Companies (Accounting Standards) Rules, 2006 Rules (“the Rules”). These rules incorporated AS-11 (2004), without any change.

Now, how do these rules deal with the apparent contradiction between the Act, Schedule-VI, and AS-11 (2004)? In a unique answer, perhaps for the first time in the Indian legislative history, the Rules contain a footnote overriding the parent Act. They actually say “…the accounting treatment… contained in this standard, is required to be followed irrespective of the relevant provision of Schedule-VI to the Companies Act, 1956”.

Prima facie, this seems to be untenable since a Rule can never contradict an Act passed by Parliament. However, the entire gamut of corporate world seems to be falling in line with the Rules.

Interestingly, the Rules themselves say at a different place (and in the main body, unlike a footnote as above) that the Act is superior and intended to prevail. In order to make things more complex, the ICAI has just gone and withdrawn its 2003 November announcement about the primacy of the Companies Act.

Even for argument’s sake, assuming the Rule is enforceable, when does it come into effect? The answer is not so simple. Some say, it comes into effect from December 7, 2007, when the Rules were promulgated; others point to the fact that the Rules themselves state that the accounting standards come into effect in respect of accounting periods commencing on or after the publication of these accounting standards; which means accounting periods commencing after December 7, 2006.

All this would have been very funny if it were not for the fact that each different interpretation signifies a difference of sometimes hundreds of crores for major corporates. As of now everything is permissible and so nuanced investors would have to read the fine print in the “Notes to Accounts”, to understand which view or interpretation a particular company has taken and the impact it has on its financials.

The ICAI or other regulators have not come out with any clarifications. The next step in this drama would be, I guess, that of the regulators, who would later in the day come out with different clarifications, to be applied retrospectively. These clarifications might or might not address all the various issues raised above. This would mean more confusion and cause a lot of pain for corporates who have already taken different views and would again have to retrospectively adjust their accounts. The less said about the travails of the investors and analysts the better.

This small instance is symptomatic of the confusion that we should tackle prior to going down the route of major changes in our accounting framework.

This article appeared in the 27 August 2007 edition of Business Standard, which is available at this link.