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