The decade ahead

The first and perhaps the most significant trend is the all
pervasive impact of information technology. IT changes not merely the methods by
which financial information is produced, but can significantly influence the
content of that information, its form and its frequency of presentation, as also
the role of the auditor.

Information technology makes it possible for information to
be produced, analysed and collated very fast and this will generate demands for
financial information to be prepared and presented to shareholders on an
on-line, real-time basis. The annual general-purpose financial statement as now
produced in the form of the annual report may well disappear. In fact we are
very fast reaching the stage where, as a cynic when referring to the annual
report put it, “Analysts do not need it and shareholders don’t read it”.
Electronic filing of myriad statutory reports with regulatory authorities will
also become the order of the day and audit firms will have to increasingly
embrace automation in their auditing processes totally to handle this.

There will be a fundamental shift in the objective of audit.
Arithmetical accuracy of data generated through electronic systems will be taken
for granted and emphasis will shift to the validity of the input data and the
meaningful evaluation of the outputs generated. Higher level skills will
therefore be needed to make the resultant value judgments.

The development of the eXtensible Business Reporting Language
(XBRL) will be greatly accelerated. XBRL assigns a tag to each individual data
item in financial information containing contextual information such as
accounting period, company name, currency of use, etc. This makes it possible to
identify, extract, exchange, manipulate and report data quickly and easily. XBRL
will revolutionise financial reporting by making it possible for anyone who
wants to use financial information to analyse it, re-use it and exchange it in
any desired form. This can improve the transparency of financial statements and
returns filed with regulatory authorities and XBRL filings will become
mandatory. Already in the UK, XBRL filings have been made mandatory for all
corporate tax returns by 2011.

Significant progress has already been made in the development
of XBRL software throughout the world. The International Accounting Standards
Committee Foundation has developed IFRS-GP and software has been developed to
tag companies’ reported data and to validate the accuracy of self-tags for SEC
filings in the US. In India also, the project for XBRL development has been
assigned to a sub-committee of SEBI’s Standing Committee on Disclosure and
Accounting Standards (SCODA).

A second significant trend which can be identified is the
impact of globalisation in general and the development of international
standards of accounting and auditing in particular. India’s emergence as one of
the fastest growing members of the world economy carries with it the necessity
that it should rapidly align its financial systems with international practices.
Adoption of international accounting standards by 2011, as announced, is an
essential step in that direction. However, there are certain
aspects of this decision which need to be considered.

First, there is the oft-repeated complaint that accounting
standards are increasingly becoming too academic and divorced from practical
considerations. It is said that because of this approach, financial outputs are
often at odds with economic reality. It is also claimed that accounting
standards are becoming more complex. That there is merit in this claim is
obvious from the fact that the International Accounting Standards Board (IASB)
itself has recognised the need for reducing complexity in some standards. Thus,
it has recently issued a discussion paper on ‘Reducing complexity in reporting
financial instruments’. This paper argues that the many ways of measuring
financial instruments may be one main cause of complexity and while the
long-term goal should be measuring all types of financial information in the
same way, there will have to be an intermediate approach which must (a) provide
relevant and easily understood information; (b) be consistent with the long-term
measurement objective of fair value; (c) increase the number of financial
instruments measured at fair value; (d) not increase complexity, and (e) be
significant enough to justify the costs of the change.

Second, there is the growing debate between principle-based standards as proposed by IASB and rule-based standards as in US-GAAP. Both carry certain risks. The SEC in the U.S. argues that principle-based standards carry the risk of poor judgments which could be second-guessed by hindsight, whereas rule-based standards provide clarity and ensure risk. However the Enron, Worldcom, etc. debacles clearly show that rule-based standards are not free from risk as they can be easily circum-vented. The more -fundamental objection to rule-based standards, however, is their unsuitability as a basis for international standards. Rule-based standards are derived in the context of the environment in which they are developed and a rule which is appropriate in one jurisdiction may be wholly inappropriate in another jurisdiction with a different environment. In order to develop a single international standard, IASB and FASB are progressing along the road of convergence of IFRS with US-GAAP, but there is increasing concern that what may finally emerge willbe principle-based standards with rules.

But by far the most important  area of concern  is the growing trend towards ‘fair-value’ accounting in international standards. As a long-term goal, the concept of ‘fair-value’ accounting is unexceptional. It significantly enhances the role of financial information as a tool for making investment decisions and it obviates the ‘movement’ errors which occur when the values of assets and liabilities change over a period of time. However, there are significant difficulties in determining fair value and when fair value is based on estimation and guesswork, ‘measurement’ errors can occur.

IASB has in November 2006 issued a discussion paper titled ‘Fair Value Measurement’ which incorporates a definition of fair value as “the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date”. This borrows the definition used in a standard issued by FASB two months earlier, but the important difference is that whereas the term ‘fair value’ is used restrictively in US-GAAP to cover financial instruments and business combinations, it is used more extensively in IFRS to cover most assets and liabilities.

The big problem is that in practice, and certainly in developing countries like India, there often does not exist a market in which orderly transactions can take place between participants. Therefore ‘fair value’ will have to be estimated by the preparers of financial information and these values would be subject to the significant risk of ‘measurement’ errors, both deliberate and in good faith. Auditors also could become more dependent on managements’ judgment and as Warren Buffet has so aptly put it, marking to market could well become marking to myth.

Globalisation also will have an impact on the regulatory framework of the auditing profession. In the U.S., the Public Company Accounting Oversight Board (PCAOB) established under the Sarbanes-Oxley Act is required to exercise oversight over overseas audit firms which audit U.S. listed companies or their subsidiaries wherever located. PCAOB teams have already started examination of audit firms in India. In a recent interview, the Head of Audit Regulation of the European Commission has said that the Commission is consulting on how to deal with auditors from non-EU jurisdictions – ‘third countries’ – who audit third-country entities listed in EU regulated markets. The question is whether third-country auditors should be subject to registration requirements and over-sight by EU member states or whether reliance could be placed on the third-country audit registration and oversight authorities. Clearly in making that decision, an important consideration will be the level of public oversight in the regulation of the profession and pressure will mount for this oversight to be by a public regulator and not by the Institute.

A third significant trend which can affect the profession is the growing importance of corporate governance and its impact on the role of audit. The failure of major corporations like Enr on , Worldcom, etc. in the U.S., Royal Ahold in the Netherlands, Parmalet in Italy, etc. has highlighted the fact that corporate responsibility is the central issue which business needs to address. While this has resulted in a spate of regulatory pronouncements and statutes whereby policy makers seek assurance that business delivers sustainable and responsible outcomes, it also demands that business policies are supported by accurate and reliable information and the systems, processes and strategies that produce that information and that there is independent assurance in this area. This is a growing concern which will provide both future risk and opportunity for the profession and also re-define  the role of audit.

An auditor has two roles, first, to provide assurance regarding the reliability of financial information as the basis of investment decisions, and second, to give an opinion on the stewardship performance of the management. Traditionally the profession has given prominence to the first role and largely ignored the second. However in the changed environment, the roles will reverse. Auditors will be required to increasingly give assurance to shareholders on the ‘stewardship’ aspect rather than on the ‘decision usefulness’ aspect. This will mean that shareholders will want greater information and assurance on the risks and uncertainties that affect numbers in the financial statements arising from subjective judgments by management regarding revenue and cost recognition. Therefore, emphasis will shift from an opinion merely on the true and fair aspects of financial statements to value judgments on the existence and adequacy of controls and the relationship between finance and risk.

Risk management willbecome a major area of concern for managements and consequently for the auditor. He will need to examine and evaluate the methods by which managements identify risk, and devise and administer methods by which risks are controlled, managed and reported. He will no longer be able to avoid responsibility for failure to detect high-level collusive fraud and will need to devise new approaches to deal with it. He will need to be more pro-active, that is, identify work which is needed and do it before being asked to and will need to ensure that the work he does is relevant and valuable to the client. Managements will also have to accept greater Corporate Social Responsibility (CSR) including in areas of sustainable growth and the auditor will need to audit and monitor these initiatives. All of this will mean that auditors will have to possess wider skills, greatly increase their productivity and create multi-disciplinary firms.

A final trend which we need to recognise is the impact of restructuring in the profession. There are two major themes which will inevitably change the structure of the profession. The first is the growing process of consolidation within the profession, and the second, the continued ability of the profession to attract talent.

The decade which has ended has seen a process of consolidation within the profession whereby the Big-8 have become the Big-4 and a second level of international firms have grown significantly in size. In this process, smaller firms have found it difficult to continue independent existence and have scrambled to join the international firms. The growing dominance of these big international firms and particularly the Big-4 has raised concerns of regulators in many countries. In a recent survey of the investor community in the UK, 25% of the respondents were concerned that the lack of competition could be risking audit quality. However, a third of the same respondents also said that if there was a switch away from a Big-4 firm, they would review their investment decisions.

There have been demands for regulation to restrict this dominance, but clearly that is not the answer. The solution appears to be for second-tier firms to consolidate into larger entities and offer meaningful competition to the Big-4. To create this ‘reputational competition’ they need a better understanding of what constitutes a ‘great firm’. It has been claimed that the outstanding characteristics of a great firm are :- (a) significant sustainable profitable growth; (b) the right type of client base providing the right type of work at the right fees; and (c) the ability to attract and retain quality people. It is also claimed that to acquire these characteristics, these consolidated second-tier firms will need to address certain fundamental issues, namely, (a) the need for a well-planned strategy for the future; (b)    acquisition  and retention  of high-quality staff; (c)    leadership at all levels within the firm; (d) concentration on service lines in which the firm excels and avoidance of service lines where it does not; and (e) understanding client expectations and surpassing them.

An equally important aspect is a change in mindset. The profession must give up its dependence on work where it has a protective position and must no longer expect work as a matter of right. Rather it must be willing to sustain its business development through competition, both within and without the profession. Only then will it force itself to take steps to acquire a ‘reputational’ advantage through a track record of first-rate work.

The most crucial factor which will affect the profession’s future will however be its ability to attract and retain talent. With globalisation and a fast growing economy, one of the major constraints for the economy will be the shortage of talent and the resultant competition for it. Institutes in other countries have already addressed this issue and taken proactive action. Thus in the UK, the English Institute introduced some time back a system whereby training for an associate who is not in practice is extended to employers in several countries, including a proposed extension to India. In March 2006, it launched the Pathway Programme which enables professionals with other accountancy qualifications and five years experience also to obtain an associate qualification after passing an ‘examination of experience’. Finally, it has modified its examinations syllabus to enable entrants to take the examination in phases. Many other Institutes may follow this example and the ‘articleship’ system as we know it may no longer remain as the only vehicle for entry into the profession and audit experience may soon become an optional requirement.

If the profession has to address adequately the challenges created by the trends we have identified, the two key drivers which will be needed in the coming decade will be quality and integrity.

The Financial Reporting Council in the UK recently published a paper on ‘Promoting Audit Quality’ and a framework which admirably summarises the key drivers of audit quality. These are (a) culture within the firm; (b) skills and personal qualities of – 1 partners and staff; (c) effectiveness of the audit process; (d) reliability and usefulness of audit reporting; and (e) ability to respond to factors outside the control of auditors affecting audit quality.

Confidence in the auditor’s integrity is fundamental to his work. To inspire this confidence, he must be seen to be honest, truthful and fair, compliant with the concept of social responsibility, open and concerned with the interests of all stakeholders and demonstrative of taking corrective action where necessary. Integrity has to be underpinned by moral values and demonstration of scepticism, per-severance and ability to withstand pressure in the face of opposition.

As I look back over the last fifty years, I share a feeling of satisfaction that I have been part of a profession which has grown so fast and with so much success. It has done so because it has recognised early and been able to adapt better and faster than many other professions to the changing aspects of business and to exploit the opportunities which this changing aspect has offered. I have no doubt that in the coming decade, we will continue to remain the most dynamic seekers of new business opportunities if we continue to exhibit the qualities which have made this possible, namely, continually updated skills, integrity, social responsibility and strong regulation which protects the ‘brand equity’ of the Chartered Accountant.