The collapse of companies without warning signals has eroded the trust in the financial reporting system. There also appears to be a confusion between what constitutes ‘business failure’ and ‘financial reporting failure’.
By PK Ghose
In recent times, there have been several corporate collapses in India and across the world. Most recently audited statements of these companies provided no signals of stress; in fact, some even received favourable agency ratings. The collapse of companies without warning signals has eroded the trust in the financial reporting system. There also appears to be a confusion between what constitutes ‘business failure’ and ‘financial reporting failure’. Given the credibility gap and crisis of confidence in the financial reporting system, if issues are to be addressed, merely focusing on audit quality will not suffice. Corrective steps are needed in all components of the financial reporting ecosystem, thereby addressing the expectation gap, which investors and regulators have on the audit function.
In India, auditors operate in a highly complex regulatory environment due to overlap of regulators (SEBI, NFRA, RBI, IRDA, MCA). The first challenge is to identify a nodal regulator who not only enacts regulations, but also monitors financial reporting and audit function. While NFRA’s regulatory oversight is welcome, its role should not be limited to enforcing compliance, but also in nurturing the growth of the audit profession. Radical legislative changes are required in auditing standards to focus on fraud prevention and detection; consider mandating forensic audit of high-risk areas with the use of digital tools and encourage technology usage in the audit process. Infrastructure and training facilities are needed to upgrade the audit fraternity.
Financial reporting: It should include event-based and periodic disclosures, ratios and other metrics. Event-based disclosures could cover changes in credit rating, early warning of stress signals. Periodic disclosures on ageing of assets and liabilities, information on maturity profiles, review accounting of intangibles and, particularly, eliminate ‘indefinite life’ of intangible assets and tighten disclosures around ‘unbilled revenue’. To make financial statements aberration-free, adjustments due to ‘mark-to-market’ should be taken through P&L account. Impairment testing, which is highly subjective, needs a tougher auditor stance. Goodwill on acquisitions should be written off over five years. While simplification of financial reporting remains critical, and biannual reporting may be considered, regulatory and legislative changes must be consistent with ease of doing business.
Multidisciplinary firms with specialist skills like tax, technology, analytics and forensics expertise are essential to audit executions; moreover, audit quality is enhanced when a firm can bring depth of expertise in other disciplines to their audits. But it is recommended that statutory auditors must not do consulting work due to perceived conflict of interest and the fact that the ‘Chinese wall’ is really a myth.
Empowering audit committee: Corporate boards need strong leadership from their independent audit committees. Reforms may consider code of conduct for independent directors and audit committees to record dissent and intimate SEBI along with tendering the process of appointing internal and external auditors. Mandating audit committees to seek independent reviews can strengthen related-party transaction (RPT) processes. All dues from related parties outstanding beyond a specified period must be disclosed in financial statements. Also, the definition of related parties and the disclosure requirements should consider complex structures that have been used by companies to avoid reporting as related parties. Mandatory involvement of specialists such as valuers, actuaries in financial reporting of public interest entities needs to be considered along with a mechanism for their oversight and accountability.
Ind AS has brought extensive use of fair value in financial statements, both for measurement as well as disclosure purposes. It involves significant judgement and potential for abuse. So, there is a need to develop greater consistency in how fair value is determined with the involvement of relevant experts and specialists, who must also be monitored. Joint audits should not be made mandatory because of issues on cost of compliance as well as dilution of responsibility, but there is merit in recommending joint audit to the financial services sector where majority of frauds have occurred.
Whistle-blower mechanism: Considering the possibilities of hostile repercussions, ‘blowing the whistle’ may not be easy for auditors, who must not only have access to regulators to issue advance warnings of an impending disaster, they must also be fortified by a whistle-blowing mechanism.
To be effective, banning an audit firm without proven wilful misconduct is not a solution. The reforms need to focus on the financial reporting ecosystem, inclusive of the multiple perspective that comprise financial reporting.