PANEL DISCUSSION ON UTILITY OF FINANCIAL STATEMENTS AND RELEVANCE OF AUDIT AT THE 10TH Ind AS RSC

A panel discussion on the ‘Utility of Financial Statements and Relevance of Audit’ was the highlight of the 10^th Ind AS Residential Study Course (RSC) held at the Alila Diwa Hyatt in Goa from 5^th to 8^th March, 2020.

The panellists represented various stakeholder groups related to financial statements: Mr Raj Mullick, Senior Executive Vice-President at Reliance Industries Ltd. from the preparers’ side; Mr. Nilesh Vikamsey, Past President of the ICAI representing the auditor fraternity; Mr. Jigar Shah, CEO, Kimeng Securities India Pvt. Ltd. and also an analyst; and Mr. Prashant Jain, Chief Investment Officer of HDFC AMC (a fund manager). The discussion was moderated by Mr. Sandeep Shah, CA. This report on the panel discussion is for the readers of the BCAJ who would benefit immensely considering the present situation relating to audit of financial statements.

INITIAL REMARKS

Preparers’ Perspective:

Mr. Raj Mullick began by indicating that the utility of the financial statements lay at two extreme ends; whilst they provide a lot of value to certain classes of users such as analysts, government authorities and bankers, they are often relegated to the dustbin by certain other users, including some shareholders. However, generally financial statements are relevant to various stakeholders like shareholders, government authorities, bankers, analysts, suppliers and customers, each of whom looks at specific aspects as per their requirements and serve as an important communication tool on various matters like vision, mission and strategy of the entity, its leadership, dividend policy and CSR activities, amongst others.

He highlighted that there are several challenges which could hamper their utility, including the sheer size of the content, the use of several technical jargons like MAT, Deferred Tax, OCI, ESOP, etc. Some of these challenges could be overcome by disclosure of sufficient qualitative and quantitative information covering impact analysis of future events and other explanatory and proactive disclosures so as to meet the varying needs of lenders, analysts and also credit rating agencies.

On the role of the finance team in making the financial statements more relevant and reliable, he highlighted various steps which could be taken as under:

(a) Working closely with the CEO;

(b) Establishing appropriate accounting policies;

(c) Reflecting the nature of the business in the financial statements; and

(d) Disclosing critical estimates and judgements.

Finally, Mr. Mullick stated that the role of the auditors is of paramount importance since they provide an assurance on the completeness of the financial statements and their compliance with the generally-accepted accounting principles. He also emphasised that by performing systematic, in-depth reviews of corporate controls, the auditors help ensure that a company avoids coming under regulatory scrutiny. He cautioned that going forward, for auditors to be relevant they need to go much beyond numbers and be more tech-savvy and exhibit a better understanding of the business.

Auditors’ Perspective:

Mr. Nilesh Vikamsey began by stating that for (this) audience the relevance of the financial statements and the utility of audit is a no-brainer in spite of some recent ‘accidents’. He indicated that financial statements are relevant to the following sets of users:

(i) Shareholders, managements, potential investors and promoters;

(ii) Lenders, analysts, rating companies and potential lenders;

(iii) Government and tax authorities;

(iv) Regulators like SEBI, MCA and RBI.

He lamented the fact that in the past even when the auditors had qualified the financial statements of a particular company on several counts, including on ‘going concern’ issues, large funding was provided to it mainly on the security of its brand, which raised a doubt as to whether the intended users took the financial statements seriously.

According to him, the financial statements reflect on matters involving governance, risks, estimates, contingencies, etc. which may not always be a focus point of the various users, and hence their relevance and utility could get diluted. Besides, the credit and market risk disclosures need improvement from the current boiler plate / template-ised disclosures.

Another area where there was enough ammunition provided by the financial statements was the red flags (which may not be always acted upon by the users), on issues such as:

(1)   Rising debt-equity ratio;

(2)   Capitalising revenue expenditure;

(3)   Rising fixed assets without corresponding increase in production and / or sales;

(4)   Large ‘other expenses’ in the P&L account;

(5)   Rising accounts receivable and inventory compared with sales;

(6)   Higher or lower ‘other income’ as compared to ‘revenue from operations’.

Mr. Vikamsey also touched upon disclosure initiatives at the international level to address issues around which accounting policies need to be disclosed, defining materiality, better organised entity-specific disclosures on performance, working capital management, etc., improving the structure and content of financial statements with new sub-totals (EIBDTA) and notes on management performance measures.

He pointed out that in spite of the recent aberrations due partly to the greed of some members and which needed to be tempered, the role of auditors will always remain relevant. However, they would need to embrace greater digitisation which would result in sampling getting replaced with AI and routine operations like reconciliation being automated. Going forward, the auditors would need to adopt a middle path between scepticism and investigation. Various reporting initiatives like KAMS, ICFR CARO, LFAR, etc. provide useful insights to analysts, investors and regulators. Moreover, independent directors need to see greater value in the audit process and need to don the auditor’s hat to keep pushing the management.

Analysts’ Perspective:

Mr. Jigar Shah stressed that the utility and relevance of the financial statements can be improved by building ‘additional, relevant, non-conventional’ disclosures, especially around predicting future events, diversity and ESG (Environment, Social and Corporate Governance) which would be a win-win situation for all stakeholders. Earnings may not always necessarily represent the bottom line and may not have a correlation to the market capitalisation of the entity due to various reasons like contingent liabilities, whistle-blower complaints, etc.

On the question of asset impairment, he observed that it is generally done only in times of an extreme business cycle, or when the business is about to be sold. He emphasised a more regular and vigorous assessment of asset impairment due to various technological changes like 5G, IOT and other matters like climate change and sustainability which could have an impact on industries like automobiles (emission norms, electric vehicles), cement (penalties for flouting pollution norms), real estate (climate change and global warming resulting in destruction of real estate in coastal cities due to floods), general insurance (impact of climate change on underwriting models) and IT (impact due to water crisis in cities like Bangalore and Chennai).

Another area where he felt that more granular disclosures were needed was with regard to intangibles in certain specific industries like pharma, banks / finance companies, consumer goods companies and so on on matters like expenses on brands, digital initiatives, customer acquisition, technology development (because as per the current accounting standards, any expenses on self-generated intangibles need to be expenses off and may not always be completely disclosed).

On audit quality and its relevance, Mr. Jigar Shah felt that the same is largely maintained and it would not be proper to paint everyone with the same brush. The role of audit is also likely to increase in the coming days due to various additional reporting requirements under CARO. He also felt that auditors should not resign immediately but must report.

Fund Managers’ / Investors’ Perspective:

Mr. Prashant Jain started by stating that as an investor there are two mistakes which need to be guarded against: the first is to avoid investments in entities whose value is likely to fall, and the other is to miss investing in entities whose value is likely to rise. Whilst the financial statements generally provide clues to the first situation if one reads the notes and other information in detail and identifies any aggressive accounting policies and other red flags, the same may not be true in the case of the latter. In his view the balance sheet and the cash flows are more important and relevant from their long-term value perspective than the Profit and Loss statement which is more temporary in nature. He recalled that one of his earliest learnings from a senior fund manager was that the bottom line is sanity, the top line is vanity but cash is reality!

It would be wrong to link failures entirely to the financial statements, except in situations like severe ALM mismatches or aggressive accounting policies since they could arise due to various other reasons like government policies, competitor actions, failed acquisitions and incorrect capital allocation, amongst others.

Mr. Jain felt that there could be better quality disclosures on certain matters such as:

(A) Impact on the financial statements due to non-routine matters like significant changes in oil prices, foreign exchange volatility in case an entity has operations in several geographies;

(B) The reasons for recording huge amounts as goodwill in tune with the underlying performance of the group companies;

(C) The impact on the financial statements due to long-term leases where there is a lower profitability in the initial years, and in situations where the entity keeps on entering into new leases continuously.

PANEL DISCUSSION

After the above observations, moderator Sandeep Shah put forth various questions arising out of them and on certain other matters, resulting in a healthy discussion amongst the panellists. A summary of the views of the panellists on various matters is provided here:

(i) Whether rigorous examination by auditors is undertaken: The primary responsibility for the preparation of the financial statements is that of the management and the auditors generally conduct a rigorous examination thereof. However, the quality of disclosures could improve and greater scepticism on their part is warranted in view of the recent failures;

(ii) Whether audit is a commodity: There were differing views on this. The views in support thereof arose primarily from the growth expectations and undercutting of fees due to rotation, especially amongst the larger firms. However, firms are now evaluating their risk profiling of clients and increasingly resorting to resignations within the regulatory framework. On the other hand, since in certain cases the auditors grow with the companies, there is no commoditisation and it is up to the entity whether it wants to do so;

(iii) Competitiveness of audit fees: On the question whether the fees paid to the auditors are reasonable vis-a-vis the complexity involved, it was felt that there was scope for improvement since the lower fees are partly due to the lower rate of growth in the compensation levels of the white-collar employees in the past 20 years compared to the blue-collar employees, such as drivers;

(iv) Audit quality and related disclosures: The quality of the audit firms is primarily driven by the partners and the staff both in terms of their brand value and technical competence. However, adequate disclosures are not made in respect of the credibility of the team members except for the name of the signing partner. It was felt that a rating of the audit firms is the need of the hour. The AQI proposed in the MCA consultation paper could also be a step in that direction, though the ICAI has not made much progress in the matter. Many small firms are quite meticulous in undertaking their assignments. In sum, it was noted that in many cases, at the time of acquisition the acquirer insists on firms of a certain standing to ensure quality;

(v) Role of auditors in evaluation of business and industry impact: It is not the responsibility of the auditors to evaluate the future impact on the entity’s business since they are not industry experts, except that they may only highlight the risks. It was suggested that the management may, as part of the annual report, give specific disclosures about the possible pricing and financial implications due to the impact of technology changes on their business in the foreseeable future;

(vi) Role of technology and digitisation on the audit function: This will result in a revised set of skills on the part of the auditors around data inputs / querying which would be very dynamic in nature;

(vii) Relevance and utility of the MD&A: There were mixed reactions on its utility. Whilst, on the one hand, it serves as a useful communication tool especially for the larger companies, on the other it always tends to be optimistic and a report card of the present without providing a meaningful analysis of the future plans of the business. Accordingly, it was felt that it does not merit more than a passing interest;

(viii) Relevance of investor presentations: Since they generally tend to be more detailed than the MD&A, they are more relevant to the analysts due to their interactive nature which helps them in updating their valuation models. However, the forward-looking statements made therein are quite often not substantive and tend to be optimistic and biased; hence they should be read in conjunction with the detailed notes in the financial statements, because the devil lies in the details;

(ix) Transition to Ind AS – whether beneficial: Whilst there is no doubt that Ind AS provides better quality of disclosures, it was felt that the earlier format of the balance sheet was more reader-friendly since it provides the sum total of the various line items at a glance as against the ‘Current’ and ‘Non-Current’ classification of all line items under Ind AS, which could be summarised. Further, the concept of ‘Mark to Market’ presents challenges in analysing the financial position and results in a meaningful manner;

(x) Earnings management: The greatest challenge therein lies in managing the expectation mismatch. In certain situations, it could be used as a legitimate tool by the management by cutting certain discretionary costs like advertising or delaying capital expenditure; in other situations, it may not be justified, especially if it is achieved through aggressive and questionable accounting policies. It was, however, agreed that over a period of time the same would be mitigated through a natural process of reconciliation and tie-up with the market forces coupled with greater regulatory scrutiny;

(xi) Sufficiency of the current financial statements framework to all industries: Whilst it was largely felt that the current financial statements framework is sufficient for most industries, in certain industries such as media, real estate, airlines, multiplexes, pharma, etc., it may not always provide meaningful and relevant information like the extent of land parcels (real estate), products, USFDA inspections (pharma), impact of long-term leases (airlines, multiplexes) and IPR (media);

(xii) Usefulness of joint audit: It does provide value and add to the quality of the audit, especially in the case of larger entities; the experience has been generally good in countries which have mandated it. However, care needs to be exercised that whilst allocating the work no significant areas are left out. For the smaller companies it may result in increased cost;

(xiii) Incentives for auditors: The main incentive and motivating factor for an auditor is being a member of the ICAI. However, considering his role as a solution provider, one of the motivating factors would be that his recommendations are accepted. There can be no greater feather in the cap than when the financial statements certified by him get an award from the ICAI for the best-presented accounts.

CONCLUSION