Article
There cannot be any other appropriate time to write this
article, when the US financial crisis has engulfed the financial sectors across
the globe. This financial storm is no doubt worse than the Great Depression of
1930, and many more aftershocks are yet to be witnessed. The strongest and the
most respected institutions have either been declared defaulters or are in
near-default situations. Financial health of many companies reported to be very
strong in one quarter is suddenly showing a gloomy picture in the subsequent
quarter and declaring insolvency in the quarter next. The role of an auditor has
come under the scanner.
All these simply reflect that unexpected changes
in the economy have come faster than its capacity to meet the ‘challenges of
change’. Due to this paradigm shift in financial sectors the traditional
approach to auditing has lost its shine. At the same time, Auditor’s Report will
now be the sovereign document providing the testimony to the health of the
company as auditors whilst reporting consider the concept of ‘going concern’.
This Article aims to provide some newer approach for audits of financial
intermediaries.
Financial Intermediaries :
Financial intermediaries are broadly classified into two
types :
(1) Advisory or fee-based financial intermediary,
(2) Asset-based financial intermediary.
Whereas the advisory/fee-based financial intermediaries
charge fees for services rendered, the asset-based financial intermediaries earn
their income from interest spread or say from difference in currencies. Many
financial intermediaries also have their proprietary business models in addition
to providing services to their clients. Some of the financial intermediaries
are :
à
Stockbrokers.
à
Portfolio Managers
à
Mutual Funds
à
Financial Institutions
à
Merchant Bankers
à
Depository Participants
à
Venture Capital Companies
à
Non-banking Financial Companies . . . . etc.
ICAI in its various pronouncements on ‘Accounting’ and
‘Auditing and Assurance’ Standards has dealt in details about the way auditing
needs to be done. In spite of that, everyday we hear about how companies have
played fast and loose with accounting norms. Therefore, an auditor needs to
equip himself with modern techniques of auditing. The following are some of the
important aspects of auditing of financial intermediaries.
Regulatory Compliances :
During the last few years, there have been substantial
regulatory and operational changes for financial intermediaries. Regulators such
as SEBI, RBI have travelled a long way in mandating the code of conduct, and
do’s and don’ts for the intermediaries. These are brought in with the objective
of improving market efficiency, transparency and preventing unfair trade
practices, and thereby raising the standards of operations.
Is business taking priority over compliances ? or it’s
otherwise, is a key indicator for hidden intentions. Irregular business
practices, weak controls and process gaps are some of the areas an auditor needs
to study. The auditor also needs to study compliance norms applicable to these
organisations, degree of adherence and probe into reasons for non-compliances.
At times, periodic compliance reports are submitted to the regulators, copy of
which needs to be obtained. Internal reports of compliance officer, and
correspondence with the regulators also need to be studied to gauge the risk of
non-compliance.
Risk Management :
As robust, flawless and seamless manufacturing activities are
paramount to survival of any manufacturing organisations, so is ‘Risk
Management’ for Financial Intermediaries. There can be various types of
risks such as credit risk, IT risk, process risk, regulator’s risk, market risk,
operational risks, etc. The nature and degree of risk depends on the business
model of the financial intermediaries. Models such as retail, agency,
proprietary, distribution, advisory will have different risks associated to its
business.
For measuring the risk, the auditor needs to employ his
analytical skills in addition to his mathematical skills. He should be in a
position to travel beyond the financial numbers and assess ‘vulnerability’.
He should be more alert in volatile market conditions as regards valuations,
open exposures, accruals or deferment of gain and liquidity positions. He needs
to see whether the risk management policies stand the test of time and there are
no human tampering or human intervention of sacrosanct risk parameters set in
the system. Exception reports, process of decision-making and documentations
also need to be studied. At times, the revenues or exposures are concentrated to
certain set of customers, branches, products or regions posing a greater threat
of defaults. The auditor needs to verify whether risk is well spread or
concentrated, and whether or not the system is capable of throwing early alerts.
Auditing under IT Environment :
Technology is a key enabler for accounting, operations and internal controls. In today’s times, companies operate in a highly complex IT structure and environment. From computerised accounting the companies have moved far away to computerised processes, operations, documentation, controls, etc. They also operate in highly fragmented environment using different softwares for different activities. Though controls have been shifted to computers, occurrences of frauds are still continuing, only the way the fraud is happening is changing.
The objective and the scope of audit does not change in an IT environment. However, the use of computer changes the processing, storage, retrieval and communication of financial information and may affect accounting and internal controls. With e-commerce, the auditor needs to develop e-audit capabilities. He needs to gather sufficient understanding of computerised environment, the source data, the data which is getting processed, the parameters and constraints used in processing the data and lastly the reliability of the output. Some of the other important audit checks are:
- Degree of security levels and policy of escalations.
- Interaction with process heads to understand and to obtain requisite reports from them.
- Reconciliations of MI5 reports with financial data.
- Testing the effectiveness of controls by performing ‘walk throughs’.
- Verify the audit trail for critical transactions and test the result outside the system.
- To study IT policy, IT business reports, compliance status, report of external expert, etc.
- If needed, have a meeting with back office/accounting software vendors.
- To verify whether end-to-end integration, process of validations, maker-checkers are in place or not.
- Review physical securities, access logs, network accounts, remote access, no. of servers, connectivity, etc.
Creative Accounting:
Creative accounting refers to accounting practices that may “follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.” They are characterised by excessive complication and use of novel ways of determining income, assets or liabilities. Such innovative and aggressive ideas are also found in accounting of financial intermediaries. These ideas/practices are used for variety of reasons which include favourable effect on share prices, improved credit rating, incentive compensation plans, promises given to private equity investors, etc. Even smaller companies sometimes resort to such practices for tax planning.
The book on ‘The Financial Numbers Game’ by Charles W. Mulford and Eugene M. Chomiskey has described in details how to detect such practices. The duty of the auditor in such circumstances is very delicate. He should be in a position to distinguish fraud from error by identifying the presence of intention. Recurrence of non-recurring items, inappropriate accruals, exotic products and innovative valuations are some of the forms of creative accounting. It is said that the great tragedies of history have occurred when both parties were right. Therefore, if some accounting treatments are ‘not wrong’, the auditor should clearly spell out that “they are not right”.
Accounting for Financial Instruments:
Accounting Standards, AS-30, 31 and 32 have been recently notified by ICAI, detailing recognition, measurement, presentation and disclosures of financial instruments, including. derivatives contracts. These standards are set to form new rules of accounting for financial products. Fair value accounting and hedge accounting are two major departures from the principles of convertism and prudence. Though the recent U.S. economic crisis has given rise to some doubts on ‘fair value accounting’, as of now it remains on the books.
The auditor needs to obtain thorough understanding of these standards, especially for derivatives contracts. Off-balance sheet exposures, marked to market valuations, fair value identification, hedge relationships are a few of the tricky situations where the auditor needs to exercise judgment. At times, in volatile market, post-balance sheet events are very critical for framing an audit opinion. The more complex is a contract, the simpler and clearer should be its accounting entries, is a fundamental rule. Even in case of sub-prime crisis, nobody knew where the ultimate loss rests – in other words – who is bearing the loss. The auditor should understand and pierce the web of complex contracts created with the help of multi-layered corporations.
It is, I repeat, necessary to apply the standards of ‘fair valuation’.
Other Common Approaches:
Apart from emphasis on above specific approaches, the auditor has to give due importance to the following procedures :
- Review internal audit reports, their scope, coverage and observations.
- Review of critical operations outsourced to external agencies.
- Review of audit committee’s observations.
- Adherence to the requirements of clause 49 for corporate governance.
- Decision-making processes, whether system-based or person-based.
- Continuous review of latest Circulars, Notifications applicable to the auditee.
- Mapping of all the procedures in a sequential flow, so as to establish reliability on final output.
- Whether there is bifurcation of own funds and securities from client fund and securities at all levels.
- Rotation of audit staff and giving them adequate training and authority to conduct audit.
- Interaction with departmental heads and review of business reports.
- Do comparative analysis with other entities in the same industry.
- Verify the transactions with related parties/ group concerns.
Conclusion :
The accounting system is currently under stress. On the one hand, creative solutions and interpretations on complex issues are put forward in the name of innovations to suit intentions and achieve objectives and on the other hand the value system is diluting.
Though the old principle of auditing, ‘Independence, Integrity, Objectivity’ coupled with competence still holds good, one needs to re-invent the audit approach. Auditor’s ‘Independence of fact’ blended with ‘Independence of appearance’ is of utmost importance to maintain public confidence and to enhance the value of audit function.
These are challenges of change. Though the challenges are tough, I have no doubt that the profession will change faster than the change and grow stronger than the challenges.
