Year: 2008

This narrative cannot begin without acknowledging a deep debt
of gratitude to two benefactors, Mr. V. D. Chowgule, and the Hinduja family, who
respectively facilitated my entry into Articles in London (1966) and passage
into industry (2002) gently, swiftly and with future prospects that could hardly
have been bettered.

An entry to ICAI membership in 1971 as a UK CA, under a
facility open up to mid 90s, and paradoxically shut during my own presidency,
gave me relief from examinations, and seemed almost providentially designed by
ICAI founding fathers, to set the duller lot free from the severer struggles
with Indian legislation, bestowing on me large leisure to brood over coming to
terms with Mumbai’s ground reality, on return from PW London Office.

On joining a large firm in India (1972), my first impressions
were of contrasts, difficult to reconcile. Firms with quality clientele to match
today’s multinational LLPs, but squeezed by an oppressive tax regime, worked in
rudimentary environments with non-existent creature comforts, the serene
antithesis of the later-day CA offices modelled after five-star lounges.
Unctuous peons donning traditional round black topis served feeble beverages —
reverentially to ‘Saabs’, obsequiously to ‘Seths’, deferentially to visiting
clients, and indifferently to other inmates.

CAs rode the high tide of sought-after tax expertise,
following doomed attempts by the business community to find cheer in the tax
regime then extant under the FERA-cum-Licence Raj, except through the most
abstruse tax planning, on a scale now hardly credible even to modern tax
planners.

The finest minds upon graduation craved Articles, enchanted
by the premium CA qualification. Some of the gems who trained during those
years, including under me, are today leaders of many sectors in India and
abroad, too numerous to recount.

Managers were deemed successful if staff rooms were empty
(there was no hot-desking then). It was seen as a sign of success (billable
hours was the main saleable product, as it is today) if the little ones were
ticking up chargeable hours in client offices, while the big ones turned
disputation into argument in tax offices, and escalated these before tax
Tribunals, — the latter appellate forum already under relentless surrender to
the rival black-gowned profession.

Members of our profession were imperceptibly but irreversibly
consigning themselves to meaner and less rewarding rungs on the ladder of
representational work. When the enduring tale of our profession is eventually
written, the scribes shall have the unenviable task of scripting a durable
record of the price we paid for neglecting the two engines that could have
navigated us to greater prosperity and good fortune — presentation skills, and
language skills. The neglect of these skills virtually handed on a platter to
MBAs and other disciplines, traditional preserves, over which CAs could easily
have retained hegemony.

The inherent tragedy of the CA in India is that — the CA Act
keeps members from doing that which is not prescribed, whereas the Advocates Act
keeps non-members from doing whatever the black-gowned profession does. So the
CA Act shackles CAs while the Advocates Act shackles competition.

Extensions of accounting like costing, management accounting
and financial management had by 70s been popularised, covered by authoritative
ICAI pronouncements, and become common enough to be put to general account. The
concept of accounting had changed, from one of maintenance of books and tracking
asset changes, to complex resource allocations and forward looking measurements
that support decisions for the efficient maximisation of profit. These
specialisms were subsumed by management consultancy, which turned esoteric, and
gradually the more lucrative work was captured by brand names, mostly non-CAs,
able to win predatorily priced assignments, and function with impunity outside
any regulatory framework whatsoever.

Gradually, all perceived ‘value added’ domains moved away
from the core attest function.

Audits had progressed, beyond the’ post factum technique of validating profit or loss and asset changes, to prescriptive regulator-driven reporting regimes, notably the requirements of October 1973 obliging verifications of capacities, turnover, production and stock quantities categorised by licensed sublimits, to be published in Annual Reports; and MAOCARO 1975 (forerunner of current CARO) requiring explicit subjective judgmental statements that broke new ground, augmenting responsibility and chargeable hours to perform extra work, without commensurate rise in fees, because clients saw little benefit to their businesses from that work. Astute, information-hungry bureaucracy had spotted an ideal intermediary to cater to regulator needs at no cost. So, over the years MAOCARO items elongated like the legendary Hanuman tail. One benefit that flowed to the membership from MAOCARO was a formal resuscitation of Internal Audit.

ICAI formed an Audit Committee on 17th September 1982, the date, I entered the Council. The ICAI President retiring on that day had lectured me on book keeping two decades back at college. I wondered if his farewell symbolised departure of quality from those hallowed premises, but was reassured to observe the elders that stayed on in the Council. They were learned men, rather serious, looking as though they would never surrender to any form of mirth, except maybe a twitch of a smile, if elected President.

Accent was as much on redistribution of work as on creation of new work; ‘Tax Audit’ was a notable milestone in creation of new work. Curiously though, the more comprehending minds among the then seniors, were, at least initially, not enthused by this source of perennial new work – it was seen as too risky.

The pet themes in rationing audits were ‘rotation’ which was rumoured tri-annually, and ‘ceiling’ which was mooted more recurrently. The latter was eventually enacted at 20 audits per partner and the former dumped, not because this was a triumph of self preservation by the old guard, but because many rotationists had done so well over the decade, as to see life differently. In the first draft of the new Companies Bill, the proposed ceiling on large audits was misprinted as 2 instead of 20 per partner. The first copies arrived as I was hosting a dinner for a former ICAI President. He had just declined a dessert that I had offered to order. Together we noticed the unexpected steep diminution in the ceiling on large audits at 2 per partner, without realising it was a misprint. He lightened the gloom by announcing that he would change his mind, and have the dessert after all, as this might be among the last occasions that it would be on offer. Obviously I had been wrong about elders not having a sense of humour – they did!

The big scramble in audit was for empanelment to win audits of nationalised banks, insurance companies and PSUs. The appearance of a senior bureaucrat with dispensing powers at any gathering could metamorphose ‘service’ into ‘servility’. This may have been the first dent in a system which had earlier taught members to aspire, but not to grovel.

Hopes about uplifting audit as a deterrent to corporate quixotry, through a convergence of statistical sampling and unprecedented advances in information technology, died early . Technology and sampling were used to boost margins by justifying drastic reductions in work and costs, by many, but almost institutionalised by a large international organisation that collapsed some years ago causing much misery. Given the disability that an auditor can neither issue summons, nor examine on oath, nor disclose the most horrendous client sins except in a court proceeding, auditing is probably destined to veer towards forensic investigations with statutory support. Some international firms have made commendable progress in this, without formal backing.

The Licence Raj also required numerous attestations – there was a boom in what was referred in vernacular as ‘certificate work’. Agents scouted impecunious young CAs even deep into the mofussil to entice ‘certifications’ of illusory end users and fictitious consumptions of the costliest imports.

Fleeing  the  shackles:

Fault lay not with the hapless membership, but in the stagnant economy and archaic regulatory shackles that offered little opportunity, except perhaps through emigration. Thousands went west, and as many gravitated to the Gulf. They did well, and did their country and calling proud.

The Council contained competent and clean professionals. But in a closed economy, an unseemly proportion of time was drained on volumes of disciplinary cases punishing puny sins – no more than tiny ads, minor indirect solicitations, and acceptance of minuscule audits without prior NOCs, mainly by members struggling for the economic necessities of life. Large established wrongdoers, including CAs outside professional practices, were seldom booked.

Tax:

Before the blossoming of other specialisms, the absorption with taxation as a discipline was near total. When established CAs of that era crossed fifty years of age, it would not have been uncommon to see their interest in the finer points of fiscal interpretations sublimated to become the principal passion of existence, replacing all other zests. 1985 broke the tax spell and ushered in Financial Services which were already waiting in the wings to come centre stage.

Finance:

The risks assumed by financial institutions in ex-tending term loans soon brought forth a new breed of CAs to help borrowers satisfy the information needs of lenders. This work quickly extended to an appraisal of justifications for projects before committing funds. The ICAI published the Back-ground Material on Project Evaluation in 1988, but well before that, entrepreneurs increasingly saw CAs as facilitators and procurers of much-needed finance, rather than number crunchers peering at small print, while big picture concerns went unnoticed. The evolution of a learned but backward looking timid lot into a dynamic pack not lacking commercial nous, became agreeably evident.

Industry :

An important lesson the profession was learning; was, that sectors outside traditional audit, especially industry sector, would value as advisors only those professionals who were providers of solutions, not those who stopped short of a solution after finding the root of a problem, howsoever painstakingly researched that finding of the problem root may be. For many of us brought up in the traditional mould, this may have been a bitter pill to swallow. But it is important to bear in mind that if the perceptions of society about us professionals do not coincide with our self perception, then it is we professionals who become irrelevant, not society, nor those who hold the purse strings that generally influence the perceptions of society.

Standards    – ASB,  IASB & IFRS

The Council did take worthy initiatives in line with world trends. Accounting Standards Board was set up in 1977. But contrary to popular impression, our thrust, at least initially, was not market-driven. I was Chairman of ASB for some years, thereafter on Steering Committees of International Accounting Standards (IAS) and finally India’s nominee on the main Board of IAS for a full Term. I worked closely with Sir David Tweedie, later IASB Chairman, and luminaries from US, Europe and Japan. International Standard Setter meetings occurred in exotic places in the world, and at times went on for nearly a week. The scholarship and erudition round the table was so profound as to be intimidating. But the humility was amazing. I once complimented Jim Lisenring, Vice-Chairman of US FASB, that his oration on the subtler aspects of financial instruments was the most brilliant piece I ever heard; and he shot back “that proves you have not been around in the world enough”. Incidentally the divide on debatable issues between the two sides of the Atlantic was at least as wide as between the two sides of the Pacific. The Board included such experienced individuals as could elucidate the most intractable technical problems with astounding clarity using examples of transactions in a small shop. Belying the irrepressibly drab image of beancounters, some delegates regaled us with the wittiest after-dinner speeches.

Installation of IFRS, including in US corporations, may well represent the single biggest opportunity for ICAI members during the next decade.

Capital markets and Bank NPAs:

For much of our formative years, my generation was awed by an authority known as the Controller of Capital Issues that obliged industry to seek our pricey attestation on intricate application forms, designed to obstruct rather than facilitate, the issue of capital or bonus shares. This controller vanished overnight, a little before the new SEBI-sponsored arrangements were fully in place, leaving an interregnum during which a number of adventurous souls including CAs had more than their share of fun.

In one of his famous plays Shakespeare has written an oft-quoted line “let us kill all lawyers”. He was terribly wrong, not only because he exaggerated the foibles and banalities of the calling he named, but because he had never met merchant bankers before he wrote that line. Had he met merchant bankers, he may not have dished out this dire prescription to others.

One of the Managing Directors at Bear Stearns (which folded up later) led the Financial Analysts in the IASB in discussing many issues including derivatives, hedge instruments, options, off-balance sheet items, etc. She would sometimes ask me how she had come through, and I would reassure her that she had not exhibited the characteristics implicit in the sounds of her firm name i.e., ‘neither ‘Bear’ nor ‘Ste(a)rn(s)’. Uncannily though, I had then, and still have today, an instinct against some of the new fangled financial instruments, and particularly their accounting.

I have a foreboding of worse disasters to come, because the malaise is no longer confined to bankers and capital market intermediaries, but includes modern CFOs, some belonging to our own profession. So obsessed are the CFOs with ‘selling’ bankable balance sheets to Analysts and Investors and presenting their Business to audiences from an external perspective, that, an in-depth expertise in specialist areas like Risks including Tax risks, and Regulatory requirements, have become for them the least important areas of their work. This folly is compounded by the cordial assent which these incorrect priorities now seem to receive, even from the more comprehending minds, in Industry and Profession.

If I were asked to muse in retrospect, on who should be regarded as the biggest offender against financial discipline, I would not accuse the business community. On the contrary, given the spate of acquisitions abroad, the Indian businessman must be seen as a defender, not offender, by those who care about the Indian Economy.

Pre-liberalisation era curbed genuine entrepreneurship, denying the scarce foreign exchange to the worthy enterprise, while at times releasing it for the not so deserving. One instance may suffice to illustrate incondite loans in foreign exchange.

A consortium of nationalised banks had lent a humongous sum in US dollars to a project spear-headed from India with some foreign individuals as stakeholders. The project was located in an island in the Indian Ocean. Costs and Interests escalated and were additionally funded. The Banking consortium sent me to investigate. With the benefit of hindsight, it would appear this was done by the lead banker, more to allay the disquiet among some bankers in the consortium, than to ascertain what went on. I turned out to be a bad choice for them. In a show of excessive confidentiality, instead of the easier route via Bahrain, I was flown east-ward and then back on a long flight across the Indian Ocean westward. I think it was intended that I have a whale of a time for a week, and return home with a tutored report. My total rejection of any alcoholic stimulant on the island and a punctilious application of mind to Books and Records soon soured the pitch. As a professional, and as a human being, I was grieved to see an instance of how the scarce resources of a poor country seemed to have been applied by those appointed to guard those resources. On return, unsurprisingly I was cold shouldered, and received only superficial acknowledgement, with just one exception. One bank official had the courage to openly support my findings, and when these ran into a dead end, the grace to orally share his suspicion that the report had been dumped. This outstanding officer later rose to be Chairman of one of the oldest nationalised banks, partially reinforcing my faith in the survival of virtue in an ocean of compromise.

Tenure in Council:

I was re-elected five times to the ICAI Council over 16 years 1982-1998.

In 1994 I became Vice-President solely because, the councillors disenchanted with me were marginally less than the number disenchanted with the other contestant who was actually a far more deserving candidate than I was.

Jack of all:

Every few years, Council resolutions expanded the list of what could be includible as permissible work to be performed by CAs. Like troops attempting to hold more ground than what their supply lines could sustain, the spread became thinnest at the core. Adjacent competencies waxed, while traditional proficiencies may have waned.

Sadly, members in industry gradually saw our Institute activities as somewhat less relevant, and in later years, one was never certain how much of the participation at seminars, was spurred by mandatory CPE.

Weaning away:

Meanwhile tribes that were initially tiny, like Company Secretaries, Internal Auditors, and Financial Analysts made considerable headway. They cultivated, inter alia, better relationships with key officials in Ministries of immense relevance to the Professions. ICAI was more established, but may have been perceived as somewhat insular by those whose opinion mattered most, during critical phases of growth and development. There was a joke that our policy towards competition appeared to be to, first disregard, thereafter ban our members joining those bodies, and after such banning had conferred upon those bodies the halo of martyrdom that ensured their survival, consider mutual exemptions from examinable subjects.

Change:

Elections had always been an undercurrent in the Council, and with exponential growth in the number of members, elective merit loomed larger. Elected councillors, could be seen as outstanding CAs who happened to have good PR, or perceived as outstanding PR persons who happened to be CAs. Fortunately, sufficient numbers of CAs of great merit still obtain on the Council. Only time can tell how many of the challenges that came along – whether it be the electronic age, the growing role of rival disciplines, or more vitallythe avalanche of Foreign Service Suppliers post 1993 – were proactively met with foresight by those at the helm including me.

New Order:

A New Order evolved in which professional services organisations, some of whom are integral parts of international networks, endeavour to offer advice using a multidisciplinary business-focussed approach.

To view the New Order as unwelcome would be an exercise in misinformation and prejudice. The change heralded much that was good and some of it exceptionally good. First of all, the New Order destroyed oligarchies that had existed earlier. Equality of opportunity is a principle far better served by the New Order in the first decade of the 21st century than was ever served during the preceding half century. Equally importantly, aspiring talented CAs unable to flourish in their own practice can now join the very large establishments more easily than they could ever have become part of the erstwhile oligarchies. Besides, it is only the New Order that has made it possible for large numbers of CAs to receive pecuniary rewards far higher than those ever expected in the past. Moreover, under the current new dispensations, the large residue is annually shared locally with remarkable fairness, and reportedly with an equity that contrasts favourably with the skewed slopes for profit sharing ordained in the past. Finally and happily, the local top brass of all the new large CA establishments in India are overwhelmingly members of ICAI.

Shangri-la :

These reminiscences could hardly be complete without a kind word for those who encouraged my drift in a turbulent upheaval from profession to industry. But for this, I would have missed out on the most rewarding and happiest working years 2002 onwards, which at this moment of writing seem to grow richer by the day. From 1966 to 2002, for 36 years, I deprecated my role in Kipling’s words – “those who report on deeds performed by others are not equal to those that perform deeds worthy of being reported”. Now I am performing the deeds, and the uniquely benign Promoter Family I closely work for, have afforded me roles, in exciting realms of modern international business and wealth creation.

In those days, the important meetings were felicitation of
the President of the Institute, which were normally held at Radio Club in
informal atmosphere and constituted important source of information about the
Institute and its activities. The other annual feature was the talk on the
Budget by late N. A. Palkhivala. These meetings were held at the Greens Hotel,
which is now no more there. The attendance by the members was large but can-not
be compared to the meetings held in later years at the Brabourne Stadium by
Forum of Free Enterprise.

I also remember the first conference held by the Society at
Taj, which was attended by many senior members of the profession and many
subjects of professional interest were discussed at the conference. The meetings
were also addressed, amongst others by R. P. Dalal, who was earlier the member
of the Income Tax Appellate Tribunal and who humorously introduced himself as
out-standing member of the Tribunal after retirement from the Tribunal. The main
characteristic of the Study Circle and Lecture meetings was the informal
atmosphere in which they were held.

But the more notable feature of the Society was that normally
the President was selected by the Committee of the past Presidents taking into
consideration the erudition and leadership qualities of the person and was
respected by the members except on one or two occasions. This healthy tradition
is continued till today. There was scope for aspiring members of the Society to
work in honorary capacity as Committee members, Secretary and Treasurer and also
without being members of the Committee. The seeds of democracy and
responsibility as good professionals were sown by the members during their work
for the Society.

Another landmark stage was reached when the Society hired the
Office of Circle Literaire for its Study Circle and lecture meetings usually
held on Wednesdays. It was not necessary to know a single word of the French
language to attend the meetings there ! ‘60, Forbes Street’ became the famous
address of BCA Society for a number of years. The larger space gave a boost to
the Study Circle and lecture meetings and the publication of the Journal of the
Society, which was issued in cyclostyled form and which was the precursor of the
present ‘The Bombay Chartered Accountant Journal’ of the Society. One cannot
forget the services of Shyam Argade, as the editor of the Journal for a number
of years. The Study Circle and Lecture meetings gave opportunity, encouragement
and confidence to the new members to participate in the meetings. The meetings
of the Managing Committee were usually followed by dinner of the Committee
members and Past Presidents, which was frequently held at Ripon Club, Opp.
Bombay University.

But the real contribution of the Society to the profession
was by its leading role in representation to the authorities concerned on tax
matters and other professional problems relating to the Companies Act,
Partnership Act, etc. and the educational programmes like Seminars, Residential
Refresher Course, Workshops, etc., I remember the stormy meeting held at the
Greens Hotel to oppose tooth and nail the introduction of Rule to certify Income
Tax Return of the clients, a move fraught with danger to the professional filing
his clients’ Tax Returns.

One of the interesting features of the social activities was
the annual picnic of the members to Mahableshwar and Matheran, Lonavala, Pune,
Malavali Fort, etc. The present generation will not be able to believe that one
of the courses organised by the Society was at Mahableshwar for a charge of Rs.6
per day including boarding. Likewise, the annual social held more or less
regularly every year provided musical programmes including veteran Music
Directors like Naushad, not to mention the Qawali programme of Shakila Banoo
Bhopali on the boat cruise. A memorable event in one of these programmes was the
failure of the brakes of the car on ‘Ghat Road’ of Homi Banaji, one of the
amiable members and President of the Society. Likewise, the distinguished
gallery of the Presidents included personalities like late S. V. Ghatalia, S. N.
Desai, and E. C. Pavri besides the trinity of Shri Dinubhai, Shri Ambalal and
Shri Narandas.

The Society was the first to organise a Residential Refresher Course at Matheran under the Presidentship of P. N. Shah, which was inaugurated by S. P. Mehta whom the Society had accepted as the Hon. Member. The faculty included Bansi Mehta and I had the opportunity to write my first paper at the RRC on the evergreen subject of depreciation, which never depreciated in its value. Since then the Society has organised the course every year and is one of the most popular programmes, for which the enrolment is full within hours of the commencement and faster than some of the listed companies’ issues. This pioneering activity was followed by other professional bodies including Western Indian Regional Council of Chartered Accounts, Chamber of Tax Consultants and All India Federation of Tax Practitioners. It was in one of such programmes that I had contributed a paper on Public Trusts, which was repeated in sub-sequent courses and became a monograph on the subject, of which revised editions were brought out from time to time, the later ones being with Shariq Contractor and Gautam Nayak.

I had the good fortune to work as Treasurer and Secretary, and finally the President of the Society in the year 1963-64 along with R. J. Damanwala as Secretary, who was very meticulous about various activities. These positions gave me the basic training of presiding over the meetings of the members and various committees, the number of which was not very large at that time.

The growth and development of the Society compelled it to acquire the larger office at Dol-Bin-Shir. The bigger office but with a smaller lift gave boost to the meetings and library activity. One interesting feature of this office was that the office of that witty, principled Chartered Accountant, late Jal Dastur was in the same building involving greater participation by him. With the holding of Residential Refresher Courses at Bangalore, Pune, Aurangabad, Goa, Jaipur, Agra, Mount Abu and Indore, the Society became an All India Society which brought in new talent from younger members like Pinakin D. Desai, Kishor Karia and seniors like Y. H. Malegam, M. L. Bhakta, K. H. Kaji and others. The special invitees or the chief guests included the President of the Institute and persons from academic field like Prof. Rege of Bombay University. The scope of the subjects was extended to Indirect Taxes, Company Law, Computers, etc., so that the RRC became the hallmark of the Society. Another first was the RRC held at Dubai, which was participated by many local members also and meetings with Government officials and fol-lowed in the evening by Harbour visit, socials and dinners in Desert Safari.

The annual budget lectures were given by S. P. Mehta for a number of years and after his demise, are being given by Soli Dastur, Senior Advocate, whose popularity is evidenced by the fact that even the Birla Hall proved too small, compelling the Society to shift the venue to the architecturally beautiful hall of Swaminarayan Sanstha with a ca-pacity of more than 2000 persons. This was followed by annual half-day meeting on the Finance Act, after it was passed in Parliament. The mile-stone programme was the Silver and the Golden Jubilee conferences, the last being inaugurated by the President of the Institute and valedictory address by Shri Chidambaram, the present Finance Minister.

The next milestone in the Society’s history was the acquisition of new office premises at Churchgate Chambers, ‘A’ Road, Mumbai, further expanded by two premises in the same building. The larger office gave a further boost to the activities of the Society led by Narayan Varma, past President of the Society, with originality and number of new ideas for the growth of the Society and vision. The Society adopted the vision with the implementation of the goals set therein as its foundation. On his initiative the Society started educational programmes with the first such programme for management training jointly with Jamnalal Bajaj Institute. The success of this programme led to the launching of several new courses one after the other, namely, Professional Accountant, Internal Audit, Corporate Directors, Arbitration, etc. and also enhanced the value of the Chartered Accountants by giving them certificate for the training, approved by the University of Mumbai.

Shri Varma also gave a thrust to the activities of the BCA Foundation, a public trust established for help to the Chartered Accountants and the stu-dents, by very large collection for the Tsunami victims, by helping them to restore the schools in Tamil Nadu and development of computer programmes. Last but not the least, on account of his interest and enthusiasm, the foundation also devoted itself to the activities under the Right to Information Act, which proved to be a very pow-erful instrument in the hands of the people.

The publication activity received a big fillip with issue of marathon tax audit manual by five joint authors, Narayan Varma, Kishor Karia, Dilip Lakhani, Sunil Kothare and myself which helped the Chartered Accountants engaged in the task of carrying out tax audit. Likewise, many other publications were brought out on the subject of various aspects of Income Tax law, Accounting Standards, Auditing’ Standards, Service Tax, International Taxation, Computers, FEMA, Indirect Taxes, etc. The fantastic utility of more than fifty publications, revised from time to time enhanced the image of the Society as educational body.

The pre-budget and post-budget representations assumed great importance and were even followed by visits to Delhi for meeting with the Chairman and members of the CBDT and officials of the Finance Ministry. Similar representations were made on Company Law, Indirect Taxes, etc. The Society was recognised for appearance before the various committees appointed by the Government for ‘simplification’ and rationalisation, like the Choksi Committee, the Committee for Rationalisation of Tax Laws, the Kelkar Committee, Vanchoo Committee, etc.

The Society also organised Press Conferences when very serious problems were involved in Tax Laws and also participated in T. V. programmes after the presentation of the Finance Bill. The can-cerous corruption did not escape the attention of the Society, resulting in appointment of a small group comprising representatives of other professional bodies to provide machinery for fighting corruption, but unfortunately, due to inherent limi-tations, the group could not make much headway.

With the liberalisation and opening of the economy to international trade, FEMA and International Taxation became very important and Study Circles and other groups made special study of the subject with a view to equip the members to deal with issues arising therefrom and the need of foreign companies for attending to their work in India. Transfer pricing was not ignored and Conferences and special programmes were annually held to discuss the various issues.

The latest development in the field of education is to develop several modules on different subjects like Service Tax, TDS, etc., for the distant education programme and though, it may face teething trouble, it will succeed ultimately in its goal of educating Chartered Accountants as well as others. The idea has been picked up by other professional bodies also.

The role of the Society for the professional development has to be considered in the context of co-ordination and rapport with the Institute of Chartered Accountants of India, our official body governing the profession. In the early 50s the Society was asked to consider whether it was necessary to continue and expand the Society and whether it was duplicating the work of the Institute. However, the majority of the members did not subscribe to this view, as they considered that the Society is performing useful role to supplement the activities of the Institute and not to supplant the official organisation, some of whose Presidents and Council members also were actively involved with the Society. Hence, every new President and Vice-President was invited to visit the Society for be stowing felicitations and discussing the professional problems with them. In addition, in some cases the President of the Institute also inaugurated the technical programmes or gave talks on current issues like Accounting & Auditing Standards. Thus, the rapport of the Society with the parent body has been excellent throughout the years.

The clinics started by the Society for guidance of members and the public for Charitable Trusts, Accounts and Audit, and Right to Information have been doing excellent work in the education of professional as well as others who attend the clinics and take advantage thereof to solve their difficulties. The other way of public education is to bring out booklets for exposition of the changes brought in by the Budget within three days in not only English but also Hindi and Gujarati languages, so that more than 40,000 copies are circulated to professionals as well as members of the public. likewise, the education of students is not overlooked by starting revisional classes for them and lower subscription for journal of the Society and attending other programmes at concessional rates.

The last lap of expansion has been acquiring the present premises at New Marine lines, equipped with facilities for library, computers, Conference Hall for about 100 persons over an area of about 2500 sq. ft.

I have been associated with the Society in different capacities as member of the Managing Committee and Core Group and Invitee as past President over more than 50 years and have been member of the various committees including Taxation, International Taxation, and Accounting & Auditing. life is an unending educational process, so that I continue to contribute to the activities of the Society by participating in its Seminars, Conferences, Brains Trust, RRC, etc. I had therefore, the opportunity to overview the growth and development of the Society from seven members to more than 8,000 members today. There is difference in professional life in the 50s and 60s of the last century when the laws and the practice were very simple, though effective. But today with the increasingly important role of the Chartered Accountant in the core subjects of Taxation and Auditing and the new fields of International Accounting & Auditing Standards, IFRS and International Taxation, FEMA, audits of Public Sector Companies, Banks and Insurance, with greater expectation by the C&AG and the new pastures of Government Accounting, Local Bodies and the whole gamut of Indirect Taxation covering Excise & Customs Duties, Modvat and Service Tax – the list is endless and the ever-increasing need for continuing professional education is amply served by the Bombay Chartered Accountants’ Society.

In view of the knowledge required on several fronts, the need of the hour is specialisation and bigger firms rendering services in all directions under one roof. This has witnessed even the amalgamation and mergers of the big eight firms into big four firms today and merger of other middling firms to cope with the need of the professional services, raising a question whether there is scope for proprietary or small firms of two or three members. But my observation of the small firms in U.S. and even European countries leads me to conclude that even the smaller firms have the scope for practising with the advantage of greater personal attention and intimate rapport with the clients and specialisation by the firms and partners only in some subjects. Time alone will show whether this prediction will turn out to be right or wrong.

The sub-prime woes in the US are a result of the excesses in the system caused by pushing the balance between risk and return beyond prudent levels. Aggressive US Banks were offering attractively priced mortgages to sub-prime borrowers in the hope that the boom in the real estate market will continue and the security cover will be more than adequate when repossession and sale becomes essential on loan default caused either by rising un-employment or firming interest rates. The prospect of being able to quickly sell these loans as COOs at a profit certainly prompted banks to lower lending standards. The continuing bullishness in the real estate market lulled credit enhancers and insurers to take on risks at a price that they would otherwise have not taken and the ultimate investors – frequently high-yield funds promoted by the very banks who originated the mortgages – to hold securitised assets at low yields emboldenedby credit insurance and softening interest rates. Once the real estate prices started correcting and interest rates firmed up, the holders had to mark-to-market the asset-backed securities incurring considerable losses and the credit enhancers/insurers who had taken leveraged bets while underwriting these risks had to suffer huge losses. Aggressive repossession of housing assets and subsequent sale in an already weak housing market caused a further slide in real estate prices, thus jeopardising the asset coverage of CDOs. This chain of events finally left the Wall Street bankers holding billions of dollars of COOs and other asset-based exotica that represent – variously sliced and diced – home loans made out to sub-prime borrowers. With the supply of these securities exceeding natural demand, when they found that there are no real buyers for these securities, they created buyers called structured investment vehicles (SIVs) who would borrow short-term money from the commercial paper market – based on good credit rating from friendly credit raters – and use the money to buy the long-term mortgage assets from these banks. The catch however is that for this game to continue, the commercial paper would need to be rolled over every few months. With the correction in real estate markets getting worse by the day, the sub-prime borrowers started defaulting in servicing their loan obligations and the value of the mortgaged homes could not cover the outstanding loans. With this, the asset-backed commercial paper market dried up, thus denying the SIVs their primary source of funding.

Under these circumstances, the’ SIV could either liquidate the mortgage securities on a forced sale basis or plead with the sponsoring bank to extend their credit lines. The problem with the first option is that the sale at distress prices will force banks to mark-to-market their holdings of similar illiquid securities worth several billion dollars causing huge losses to be booked. Banks therefore preferred the second option, so that they could continue to value their illiquid securities at ‘fantasy’ prices without providing for mark-to-market losses. In a well-functioning capital market, the SIVs would reflect the real-world prices of their underlying assets and on this basis there would be enough funding available from hard-nosed capitalists through the market mechanism. The mark-to-market valuation would necessarily reflect the distressed nature of these assets and the risk appetite of the capital providers. Some help was at hand from the US Financial Accounting Standards Board in this regard with the adoption of FASB 157 from mid-November 2007, which sought to standardise ‘fair value’ accounting. Under this dispensation, assets are classified into three levels, with the first level involving assets with prices quoted in active markets and the second level involving less-traded securities which are valued using the prices of similar assets. At the third level are securities like COOs that are not traded and are valued with the help of financial models based on a series of assumptions, known as the mark-to-model method. The accounting standards require institutions to classify securities such that the mark-to-model method is kept to the minimum and as far as possible, to value level-3 securities based on a gridded or extrapolated level-2 value. Appropriate disclosures of the methods used to estimate the fair value of assets is a requirement. Avoiding the use of market prices or proxies for market prices in preference to mark-to-model methods became increasingly difficult where the accountants sought to strictly implement the provisions of the accounting standard. If truth be told, the implementation of these standards was not uniformly strict.

One of the aspects of the problem that should concern the accounting profession is the fact that the large banks affected by the sub-prime mortgage meltdown had to take on obligations beyond what were considered contingent liabilities and factored into capital adequacy calculations. Bailing out bank-sponsored off-balance sheet vehicles such as conduits, structured investment vehicles and even money market funds beyond the formal legal ob-ligation of the sponsoring bank was at the root of the massive write-downs. This was indeed necessitated by the need to protect the hard-earned reputation of the sponsoring banks, much beyond the scope of enforceable contracts. This development has far-reaching implications for shareholders, the accounting profession, as also bank regu-lators. For shareholders, this was a risk that they never bargained for, but still had to pay for in terms of value erosion. The accounting profession would do well to revisit the level of disclosures and consider putting in place a reporting standard that requires disclosure on such qualitative and unquantifiable risks. Regulators would need to have a rethink on the adequacy of risk capital that may need to factor the financial consequences of banks opting to take on such unenforceable obligations. The dilution of the credit creation function of banks that would be the inevitable consequence of any deleveraging prescription would need to be balanced with the potential benefits of a healthier banking system.

Another lesson that is worth learning from the ongoing credit crisis and is again relevant to the accounting profession is the inappropriateness of leaning too heavily on complex risk and valuation models. The basis of the high credit rating of pools of sub-prime mortgage loans was the assumption that mortgage defaults were essentially independent of each other. This enabled credit raters to use risk models on the basis of the ‘Law of Large Numbers’ that allowed large portions of these pools to be rated AAA on the premise that the probability of a default of more than 20% of principal was very small. The reality however is that defaults in sub-prime mortgages are not independent events when confronted with a steep interest rate rise or a nationwide housing price collapse. Moreover, the dimension of market liquidity is not factored into financial models because there is no agreed method to value liquidity. Regulators need to be concerned that the soon-to-be-enforced Basel II prescriptions rely largely on the use of such discredited complex risk models. The risks to the financial system on the back of reduced capital adequacy norms based on third-party credit rating of risk assets merits a careful evaluation in the light of recent events.

The role of the auditor together with the duties and
responsibilities are contained in several provisions of the Companies Act. The
said Act and the ICAI’s Code of Ethics are very specific in terms of the roles
and responsibilities of the auditor and the ‘bounds’ within which he should
operate. The Companies Act of 1956 and the Code of Ethics of the ICAI also deal
at length with the issues relating to ‘independence’ and under which, there can
be various penalties for non-compliance.

In addition, the general understanding of the role of audit
on the part of auditors is that it is a compliance function where the auditor is
appointed to audit the books of accounts for a very specific purpose and that is
to express an opinion of ‘true and fair’. More importantly, the perception is,
had it not been for the requirement under the Companies Act, it is possible that
the client would dispense with this service.

The aforesaid factors have, in one manner or the other, had
their impact on the auditor who believes that his role is that of a compliance
officer of the company that he audits.

Companies also share the general perception that audit is
primarily a ‘compliance’ function and therefore, the auditor should restrict his
role to that of a compliance officer. This thinking sometimes also arises on
account of the belief that auditors do not ‘add value’ beyond audit of the books
of accounts; companies perceive that audit as a function exists to meet
requirements prescribed under the Companies Act with regard to proper
maintenance of books of account.

A number of accounting firms also believe that audit is
purely a compliance function and have therefore set limitations on every aspect
of their work. As a result, clients perceive very little ‘value add’ in terms of
the services rendered and whatever doubts that existed in their minds about the
role of audit gets further confirmed. Companies also use this argument whilst
fixing or negotiating auditor’s fees, little realising the services the auditor
renders.

The purpose of the article is to highlight the fact that
‘looking beyond compliance’ is very much within the overall role of compliance,
except that we need to understand the fact that it is important to shed the
traditional thinking that the role of the auditor begins and ends with pointing
out errors in accounting, non-compliance with law and getting them rectified or
reported.

2. Widening the horizon : What does ‘Auditing Beyond Compliance’ mean !

The perception of audit as a compliance function has to start
with the auditors recognising the fact that they cannot be putting ‘fetters’ on
themselves by playing merely the role as ‘compliance officers’. The important
thing to understand at this stage is, what does ‘auditing beyond compliance’
actually mean. Most professionals imagine this entails adding value in terms of
identifying areas for cost reduction and control, process improvements through
the identification of processes that do not add value, etc. Auditing Beyond
Compliance need not always involve going beyond the normal call of duty as an
auditor as one can see in the following paragraphs :

A. Adopting a pro-active approach to audit :

Most auditors fail to recognise the importance and value in
adopting a pro-active approach to auditing. Transparency and proactivity can
build trust and the auditor must recognise that this policy works in almost all
cases. For example, many auditors involve their client personnel in important
decision making such as planning of the audit. Client staff is invited for
sessions where the audit approach is explained at a broad level; what are
auditor’s expectations from the client in terms of information, the timing of
information, etc., providing general guidance to client staff in the preparation
of certain audit schedules without getting into ‘conflict of interest’
situations, etc. are some of the simple ways of going beyond compliance. Client
staff becomes very comfortable dealing with auditors who work alongside them and
help them understand and address some of the complex requirements. Helping
client staff in various procedures involved in a simple stock-take can add
value. For example, auditors can provide critical inputs in helping client staff
keep the production area clean and demarcated to facilitate stock-count.
Similarly, many auditors transfer knowledge on important areas such as revenue
recognition to enable client staff to record revenue correctly. Cut-off
procedures invariably pose a challenge and the auditor can provide inputs to
client staff achieve effectiveness of cut-off procedures. The auditor can add
significant value in the process of assisting clients without compromising on
his independence as auditor.

B. Partnering clients :

In addition to assisting clients during course of audit, many
auditors partner clients in many other ways: For example, clients face
difficulties in understanding the implications of new accounting standards and
therefore, get delighted when auditors play a pro-active and partnering role.
Thus, when AS-30 was introduced, many clients were not conversant with the
complex requirements. Auditors provided the much-needed knowledge on how to
comply with the requirements relating to ‘hedge accounting’ including
documentation requirements. Clients were advised what needed to be done right
from the beginning, so that they understood the key aspect of ‘hedge
accounting’.

Many auditors recognise the importance of keeping clients informed on all major developments in terms of new laws and accounting requirements, etc. that impact companies in general and a client in particular. As a result of this communication, auditors develop a relationship that results in a ‘no surprises’ audit. This is because, most contentious issues are discussed and resolved prior to year end, particularly with the top management to ensure that nothing is taken to the audit report as a ‘matter of qualification’. All issues that have a reporting implication are discussed well in advance and remedial action taken to ensure closure of issues. It is possible that even after all this, the auditor may decide to go ahead with a qualification in his report. But, this will be seen as clearly the last alternative, as opposed to a feeling that ‘not all options were explored’.

In the past few years, many medium-sized companies have been entering into M & A transactions, collaboration agreements and royalty agreements, etc. These are out of the ordinary transactions and involve complex accounting and other issues where the auditor can play an important role. Many auditors provide clients that are in the process of entering into such transactions, ‘on line’ accounting and other advice, so that accounting implications that have a significant bearing on the transaction can be taken into account before finalising the transaction. Also, it would provide the client with comfort that these transactions will not be subject to accounting review at the year end, since they are already ‘agreed upon’ with the auditors.

Similarly, audit of transactions on a quarterly basis, asking for confirmation of balances during the year or a date close to year end date (without diluting the effectiveness of the audit procedure), etc. are some of the ways in which significant value can be added.

C. Adhering to client deadlines, targets, etc. :

Many auditors believe in the importance of adhering to client deadlines in terms of finalising the accounts. Invariably, board meetings for adoption of accounts are fixed well in advance and cannot be postponed except at great embarrassment and heartburning. In such cases, auditors discuss the entire schedule to finalisation well in advance with the client to ensure that a timeline is drawn up that is adhered to by both parties. In case the timeline is very aggressive, the matter is taken up with management immediately and conveyed. Even in such cases, clients are asked to draw up a schedule to demonstrate that the timelines are workable and realistic. Once agreed upon, there is no question  of ‘backing  out’  at the  last moment.

Fixed timeline audits invariably lead to many arguments and heartburning because the schedule is not adhered to and the ‘blame game’ starts with the auditor invariably being held responsible for the delay. Auditors therefore maintain a very pro-active and open communication with the client where, any potential problems are escalated and thrashed out in advance only, to avoid the blame game. Auditors foresee such issues well in advance and discuss the issue with the client in an open and free manner to save on the ‘last minute’ surprises.

D. Conflict    resolution:

Auditors who do not adopt the ‘Compliance Auditor’ mindset adopt a very positive attitude towards conflict resolution. By adopting an attitude where ‘solutions need to be found if they at all exist’ as opposed to ‘how can solutions be found in such cases’, auditors go beyond the compliance approach to partner clients on a very pro-active basis and in the process add significant value. The auditor perceives his role not merely as a ‘compliance officer’ whose job it is to find mistakes, errors, deviations from accounting practices and non-compliance with law, but looks at such issues with an open mind to ascertain whether solutions exist, before reporting them to the members.

Most auditors believe that finding solutions to problems is not their ‘business’, whereas clients feel delighted when auditors perceive their role as ‘solution finders’ and not merely, ‘fault finders’. As a result, clients see great value even in cases where the auditor is constrained to report such deviations, etc. in his audit report.    .

E.  Mentoring and knowledge sharing:

An auditor gathers Significant amount of business knowledge during the course of audit. In many cases, such knowledge does not get shared and is a waste. However, many auditors share the knowledge they have acquired during course of audit by way of communication to audit committees and boards. In addition to sharing knowledge gathered by him, management letters containing areas of cost reduction, better compliance, etc. are high-lighted and discussed with the client together with a clear plan of action to avoid recurrence. Clients also feel delighted with auditors who identify areas which help remedy faults from recurring. In the process, the auditor adds value that goes beyond the ‘compliance function’.

F. Conclusion:

Adopting the right attitude towards the audit function and working beyond self-imposed constraints are options that are clearly available to the auditor without compromising on any of his duties and responsibilities as the auditor. Auditors need to recognise that playing the role of the ‘compliance officer’ does not mean putting a fetter on one’s ability and attitude towards the role. In fact, the auditor invariable gets an opportunity to play a pro-active, positive role in terms of partnering the client. Assisting the client improve upon his stakes is the best way to transform. As a matter of fact, the only way to transform is to play an active role in helping and mentoring clients change for the better.

If audit is to be given the right place and value, auditors, companies and other institutions need to work towards getting audit its rightful place and that is, it is one of the most valuable and insightful functions that is awarded to an ‘outsider’, who is provided with an opportunity to look at various transactions entered into by the company in a systematic and insightful manner, evaluate at times business risks in addition to various aspects of internal control including assessing the ‘tone at the top’ that is set by the management in the course of business.

The profession of accountancy and audit is on the threshold of significant changes in the wake of the business failures that we are witnessing by the day across the world and if it has to serve its role effectively, it will need to get rid of the shackles it has put itself under and work towards expressing itself constructively, in a pro-active manner. An auditor should work as a partner to the business by communicating to the audit committee, the board and the management in a timely manner on all important issues of which he has gained knowledge during course of audit.

Lastly, the ICAI has embarked on a massive project aimed at making the entire accounting framework IFRS compliant, by 2011. Auditors have been provided with the most valuable opportunity to assist clients in this process in several ways without, at the same time, getting conflicted out. Auditors of companies have already started advising companies what the implications are and what the impact would be in the year of transition. Companies are therefore delighted that auditors have become very pro-active and this augurs well for the profession.
 
‘Auditing Beyond Compliance’ therefore is largely, a mindset issue and auditors really need to embrace change to become more relevant to their clients by adopting a more proactive, constructive and ‘partnering’ approach towards clients. The challenge before the auditor is to become the client’s trusted advisor and partner, without losing out on ‘independence’.

Fair value accounting envisages accounting for unrealised
gain to reflect a ‘true and fair’ view of the state of affairs.

Fair valuation has brought to the notice of an investor the
true profits in companies like Enron, WorldCom and Waste Management in
the past and a host of financial services companies in the current credit market
meltdown. This is mainly because over the years, the masters of business have
been under acute pressure to show results and the masters of finance have helped
them achieve it at any cost. This has led to the use of financial and other
instruments in our financial statements, making fair valuation a very important
aspect of today’s financial statements. Also, the use of derivative instruments
has been genuinely necessitated as we globalise businesses and as countries open
up to free trade.

Let’s now examine what are the flaws with fair value
accounting. The biggest issue to fair value is that of illiquidity and its
related concern that in both boom and bust time market values are not
real. Firstly, India does not have any traded benchmarks except government
securities, and secondly, over-the-counter products are very difficult to
measure. Accordingly, we prefer not to record any perceived market losses unless
we believe they are permanent. Gains are a complete no unless realised.
Unfortunately we judge losses with the same parameters as we assess gains, but
only record the former should the diminution be permanent. How fair is that from
a ‘true and fair’ perspective ?

The reality is that companies have certain investments of a
permanent nature (HTM held to maturity) and some of a trading nature (short-term
investments or positions taken which do not actually hedge any underlying
transaction). The former is normally treated as a long-term asset where
values would be realised over the period to maturity with any diminution being
recorded should there be a perceived risk. The trading assets and
derivates which do not necessarily hedge an underlying transaction are
effectively hexposures to market risk and hence, are not intended to be held to
maturity. Accordingly, these should be marked to market at any accounting period
to bring into the results and perceived gain or loss from the asset. The fact
that such gain is permanent or temporary is not of concern. The financial
statements should reflect the results of the market risk position taken by an
entity. Our legacy accounting principles completely ignore this concept, as
these did not exist in India until the recent past when our economy opened up as
part of our reforms.

Another example where we completely ignore fair valuation is
in while recording debt with equity conversion features. We seem to
completely ignore the optionality to convert in financial statements
today. And the only way to record these is through fair valuation. Take FCCBs
for instance. Our corporates have been recording the FCCB as if the conversion
is not an option but a definite event. In the present situation where stock
prices have fallen and conversions are unlikely to happen, companies are faced
with cash redemptions and huge back-ended interest costs. Fair value accounting
would have valued the options at fair value and treated the balance as a debt.
The option value would tend to become zero near redemption should conversion
price and market price of stock converge. This would ensure an equitable profit
or loss and the optionality clearly being recorded on the balance sheet. Our
traditional cost system records the consequence of conversion as an unlikely
contingent event which ends being ignored by investors and analysts alike.

A key understanding that most accountants, bankers and CFOs
alike tend to get confused with is the difference between hedging and hedge
accounting. This is where most transactions get confused as hedges and hence are
not fair valued. Hedging is a dynamic measure where a decision-maker consciously
performs a correlation exercise to identify how an underlying market risk can be
hedged. Hedge accounting is a measurable principle which provides
guidelines as to when a derivative instrument can be regarded as a hedge to an
underlying. For example, if someone sees a correlation between the price of
apples and the price of oil, he could effectively buy oil futures to hedge
against moving apple prices. That would make his P&L immune should his
hypothesis be correct. However, this would not qualify for hedge accounting as
it may not meet the criteria of commonality of risks. However, if the hypothesis
is true, then whether hedge accounting is followed or not, the impact on the
profit and loss account would be similar.

We also seem to have mixed issues of fair value accounting with capital adequacy norms (especially in the financial services sector). The issues revolve around certain companies not reflecting pension costs in line with AS-15 or transferring of securities initially purchased as trading to HTM. These are artificial coverages to maintain adequate capital. However, there should be a distinction made in special situations between regulatory and financial capital adequacy. We tend to break or amend the financial thermometer, but do not succeed in improving the health of the patient. Instead we make the doctor’s task more difficult as the problems do not go away through accounting solutions.

Having considered fair valuation as a bane in most situations, India is possibly one of the few countries which allow asset revaluations which completely goes against the historical cost concept or prudence and is a way to fair valuation of assets provided the increase is of a permanent nature (which only restates balance sheets at replacement costs, a completely unverifiable proposition). However, as this is an age-old practice we continue it.

While it is easy to point the faults inherent in fair value accounting, it is less easy to identify an alternative method which would better fulfil the features of relevance, reliability, comparability and understand ability . Reference to historical prices would provide less comparable and much less relevant information given that the company itself views the underlyings at fair value (e.g., options). Illiquid financial instruments are a challenge, but even there the idea of reducing the scope of fair value has not resulted in credible options. An al-ternative is to ‘mark to model’. Models have been widely used and may aid transparency if backed by detailed disclosures about underlying instruments and mark to model assumptions.

Another issue debated is the relevance of fair valuation in the present markets. Should assets be marked down to reflect losses as these are not the values at which companies may sell? My own argument is that if a company sold its assets at the balance-sheet date, fair value is what it would receive for the assets, regardless of whether such values are artificially low in current markets. Irrespective of the company’s intention to hold this until markets improve, the lack of liquidity in current markets can, and has, forced companies to sell assets at these ‘artificially’ low values. In the current market situation, any accounting which fails to highlight liquidity risk in the way that fair value accounting does, would fail to capture the risk appropriately. Fair value accounting reflects the reality that investors are faced with as far as trading assets are concerned.

In the final analyses, fair value accounting as prescribed internationally and in AS-30 can best be described in the same breath as Churchill’s portrayal of democracy, “It’s the worst system with the exception of all others”. Though there is a lot of judgment involved and there is enough potential to abuse it especially in an illiquid environment, there is a lack of any other credible alternative. Though there is a need to have a vigorous debate around fair value, the fact remains that as a profession we need to. clearly understand the concept and see how we could challenge the interpretations taken by our industry and banking colleagues.

The question is : should India fully converge with IFRSs and
adopt fair value as the basis of accounting in place of ‘cost’ ? The answer
depends on the following discussion.

First, let us see reasons that are in favour of ‘cost’
forming the basis of accounting. ‘Cost’ of an item can be computed with
reasonable certainty. Cost of an item may comprise elements like cost of labour,
material, finance charges, etc. It is possible that different corporations may
define ‘cost’ differently for the purpose of accounting an item. However, once
‘cost’ is defined by a corporation for a particular purpose, it is uniformly
adopted for all purposes. All elements of cost would be such as have resulted in
an outgo of resources or in creation of an obligation if there is no immediate
outgo of resources. In short, cost of an item is by and large a figure arrived
at objectively. Such cost yields itself to verification and to its reliability.
Thus, the accounts presented under the cost-based accounting are
reliable.

Let us also see the reasons that represent weakness of the
cost basis of accounting. The most significant weakness of such accounting is
that it fails to reflect ‘changing values’ and fails to account for inflation
(or deflation) in the value of currency. Because of such weakness, it is argued,
accounts fail to reflect strength or weakness of a corporation and fail to yield
to comparison with the accounts of another corporation. This weakness is real.

Let us examine the technical soundness of the conceptual
aspect of the IFRSs. As seen above, the IFRSs are fair value-driven unlike our
present conservative approach to accounting displayed in the principle of ‘lower
of cost or net realisable value’. IFRSs require write-up of financial assets of
trading nature if their fair value exceeds the cost just the same way as they
require such assets to be scaled down if the fair value drops below the cost.
This is quite in contrast to the principle of ‘prudence’, which so far formed
the basis of accounting policies and standards.

Thus, fair value-based accounting does remove the above
weakness of cost-based accounting. Hence, accounts under the ‘fair value’ basis
will show the present value of a corporation representing the changing values of
assets, and may therefore, be more useful to users. It is argued that accounts
prepared on ‘fair value’ will be more realistic as they reflect the correct
value of a corporation.

However, the major weakness of the fair value-based
accounting is that such accounts will depend a lot on valuation of assets. Value
of an asset is determined by an open market if the asset is freely traded there,
or arrived at on the basis of such valuation models as accountants and valuers
use, or a combination of both. Fair value accounting implicitly assumes that
such value is the correct value of the asset. It is questionable whether this
implicit assumption is correct. Valuation of an asset involves a good amount of
individual skill, the making of a number of assumptions, forecasting future,
using several valuation models and accepting value arrived at under one method
or accepting an average of values arrived at under different models. Only the
naïve can be convinced that such valuation is objective as there will be a
good deal of subjectivity involved in the process of valuation.
Any valuation necessarily involves looking into the future, making assumptions,
and the terms ‘future’ and ‘uncertainty’ are synonymous. No two individuals,
astrologers included, foresee the future in the same manner. When we contemplate
the large numbers that the accounts of modern corporations contain, we can
understand the significance of a small error, intentional or otherwise,
committed in arriving at fair value of items and its impact on the truthfulness
of accounts.

If accounts adopt values discovered by an open market wherever that is possible, for the purpose of preparation of accounts, the scenario may look better than the one under which value is determined by one or more valuers. However, it is also a myth that the value discovered by the free market is always ‘true value’. In fact, the way the markets behave one may wonder whether there is at all any thing like ‘true value’, especially in the context of financial instruments whose accounting will be greatly impacted under the ‘fair value’ accounting. Stock exchanges are the epitome of free markets and continually strive to discover value of securities. But high degree of volatility in the market makes the whole exercise speculative. Falls in the share market witnessed recently the world over exploded into smithereens the myth of reliability of market valuation. If one studies the recent market trends world over, one might think that the present times are ripe to abandon ‘fair value’ accounting and revert to prudence and cost-based accounting. I repeat recent market volatility should serve to establish the weakness of the ‘fair value’ accounting.

I believe ‘fair value’ accounting makes accounting subjective and financial statements prepared on the basis of subjective criteria hardly inspire confidence. Such accounts offer a great scope for manipulation at times with mala fide intentions. The hope that auditors willdetect such manipulations willalso prove to be a myth, not because auditors do not do their job but because auditing has its own limitations which the society and the users must recognise. We must admit that with the introduction of accrual basis of accounting we had introduced some degree of subjectivity in accounting especially whilst making provisions. Still, by retaining ‘cost’ as the basis of accounting coupled with prudence we have succeeded in eliminating much of subjectivity in the accrual system of accounting. We have been able to produce by and large reliable accounts. Fair value-based accounts will raise doubt about the reliability. As fair value-based accounts are deemed to be more relevant than cost-based accounts, it appears reliability is taking a ‘back-seat’ to relevance. The issue is : should this happen, is it good for business?

Let us also see whether the fair value-based ac-counting completely serves the purpose which it avowedly professes to serve. It is said that such accounting will help determine the true value of a business, which, in accounts prepared under the cost-based accounting is not possible. However, this argument in favour misses one vital point : that the value of a business is not only a function of the value of its assets, but is also a function of intangible assets including human resources, which are mostly off-balance sheet items. Hence, these two vital elements, namely, intangible assets and human resources, which influence the value of a business, still remain outside the books of account. Let us not forget that value of business is a perception. It is at times the price paid to enter the market to eliminate competition or acquire market share.

Though the fair value-based accounting has its advantages, like any other method of accounting may have, it is a question whether the fair value should form the basis of accounting replacing the cost as a concept. Fair value-based accounting may satisfy one group of readers of accounts, but it may throw up several issues of far greater significance. For example, balance sheets and income statements prepared under the fair value-based accounting will still have to be certified as being true and fair. May be such accounts are relevant for a purpose, yet it will be difficult to say that they are reliable. We need to decide what we want: relevant accounts or reliable accounts; I am of the opinion that reliability should not be sacrificed. However, to make financial statements more relevant all that is necessary is to require managements to provide on the value of assets including intangibles. The managements should also be required to disclose all off-balance sheet liabilities. The analysts and the investors I am sure would know how to make use ‘of this information. I don’t think we should play with the reliability of financial statements. In any case, no big investments in corporations are made without undertaking what is known as ‘due diligence’ exercise. Therefore, at the time of such exercise, all required information can be elicited from the management.

To sum up, fair value-based financial statements being highly subjective, are a myth open to manipulation for ulterior purposes. The age-old concept of ‘true and fair’ is in jeopardy. I don’t think, business and the profession should take or accept the ‘risk’ – risk of manipulation. Let us stick to prudence and reliability.

2.1 Among the questions being debated are : How fair is
fair value ? How does fair valuation measure up on the principles of
relevance and reliability ? How easy is it to audit fair value ? How will
fair value accounting work in practice and what are the implications for
performance measurement ? Furthermore, the profits arising from value changes
may not have been realised, and recognition of unrealised gains goes against
the traditional prudent approach to accounting. Worse, if the unrealised
gains get distributed as dividends, it may create major liquidity and
going-concern issues. This article is an attempt to provide a balanced
assessment of this controversial and multifaceted topic.

2.2 The IASBs Framework for the Preparation and
Presentation of Financial Statements adopted by the IASB in April 2001
stated that the objective of financial statements was to provide information
about the financial position, performance and changes in financial position of
an entity that is useful to a wide range of users in making economic decisions.
As per the Framework, the four principal qualitative characteristics ‘financial
statements’ should have are ‘understandability, relevance, reliability and
comparability’. Other qualitative characteristics are
materiality, faithful representation, substance over form, neutrality,
prudence and completeness. The Framework is now under revision. In the
Exposure Draft, relevance and faithful representation are identified as key
characteristics. The enhancing qualitative characteristics are comparability,
verifiability, timeliness and understandability. Interestingly, prudence and
reliability do not find any place in the proposed revised
Framework.

2.3 The International Accounting Standards Board (IASB) has
given significant importance to fair valuation in IFRS. IASB’s new and revised
standards are based, to a great extent, on an accounting model that focuses on
fair valuation for recognition, measurement and disclosure of assets and
liabilities and that income and expenses are determined by reference to
increases and decreases in assets and liabilities, rather than the reverse, as
in the case of the historical model. Besides financial instruments, other
standards that require use of fair valuation include business combination,
employee compensation, share-based payments, impairments, intangibles,
biological assets and investment properties.

2.4 However, at this point in time fair value is definitely
not well defined even in IFRS standards, and the determination of ‘fair
value’ can be highly subjective. Though many IFRS standards require fair
valuation, there is no single standard that prescribes how to determine ‘fair
value’. Some argue that in the preparation of financial statements, IASB has
placed too much emphasis on ‘relevant information’ and has given
inadequate consideration to reliability and understandability. The danger
to relevance, reliability and comparability of financial statements using
calculated, hypothetical, non-market-based fair values was well illustrated in
an exercise conducted by an accounting firm to determine ‘employee stock
option charge’. By making changes to the input variables, all within the
allowable parameters of IFRS, option expense as a percentage of reported income
could vary as much as 40% to 155%.

2.5 Worse still, current IFRS standards include a variable
blend of both historical cost and ‘fair value’ measurement, for example :

2.6 With this hotchpotch, the understand ability prerequisite of financial statements prepared under IFRS has been compromised. Users are likely to be confused as financial statements have become an aggregation of apples and oranges.

3.1 We will now seek to understand the difference between ‘historical cost’ and ‘fair value’ accounting, how they measure up to the qualitative characteristics identified in the Framework and why prudence and reliability have lost their relevance in the changed scenario. Other alternative accounting models are: current cost, reproduction cost, replacement cost, net realisable value, value in use and deprival value. However, this article is restricted to a discussion between the historical cost and fair value approach.

3.2 Under historical cost, assets and liabilitiesare recorded at historical cost, followed by amortisation or depreciation. On the other hand in the ‘fair value’ model, assets and liabilities are recorded at the amount for which an asset or liability could be exchanged between knowledgeable and willing parties in an arm’s-length transaction. Historical cost gives no consideration to recoverability. It is only a measure of the amount expended. It has been observed that the value of an asset is represented by the future economic benefits expected to flow. The historical cost of an asset lacks this attribute, and therefore it must be supplemented by a measure of recoverable value to meet the ‘true and fair’ test. This aspect has been partly taken care of by requiring an impairment provision when recoverable amount falls below the historical carrying amount.

3.3 Some argue that a presumption of recoverability is implicit in the historical cost and amortisation, because it can be generally presumed that an entity will not pay more for an asset than it believes to be its value either in use or sale. However, the belief of asset cost recoverability may reflect entity-specific expectations that mayor may not be reasonable, and supported by observable evidence.

3.4 In contrast, ‘fair value’ stands on its own as the value could be exchanged between knowledge-able and willing parties dealing at arm’s length. Hence, the value of probable future economic benefit is reflected in the ‘fair value’. Further, ‘fair value’ of an asset needs no additional assessment of recoverable amount, because ‘fair value’ repre-sents the market’s measure of its recoverable value.

3.5 The historical cost-based accounting is premised on ‘cost-revenue matching’ objective. The ‘cost-revenue matching’ objective’ has its roots in the economic premise that costs are generally incurred to earn revenue. Business entities are set up with the objective of transforming various inputs of goods and services into outputs that can be sold for revenues that exceed the cost of inputs. The traditional accounting objective has been to recognise the cost of an asset as an expense when the revenues to which the asset is considered to contribute are recognised. Net income is then measured on the basis of matching costs with related revenues.

3.6 This traditional matching objective has undergone significant changes. It is now well accepted that an input must meet the definition of an asset to warrant capitalisation and that its cost should be carried forward only to the extent that it can be considered to be recoverable from future cash-generating activities or sale. Further, the market-place is the final arbiter in determining the recoverable value of an asset.

3.7 To carry forward an asset at historical cost that differs from its fair value results in wrong in-formation being given in later periods when the asset is ultimately realised (through sale or use) and would be violative of the basic accounting principle of cost matching revenue. It is reasoned that carrying an asset at ‘fair value’ is actually in line with the concept of ‘true and fair’.

3.8 Further, historical cost concept is not for-ward looking. In comparison, ‘fair value’ of an asset embodies market expectations and helps users to evaluate the risk and volatility dimension. In addition, financial disclosures that use ‘fair value’ provide investors with insight into prevailing market values, thereby enhancing the usefulness of finan-cial reports.

3.9 It is axiomatic that it is better to know what something is worth now than what it was worth at some time in the past. . . Historic cost data is never comparable on a firm-to-firm basis, because the costs were incurred on different dates by different firms or even within a single firm.

3.10 Today, investors are concerned with value, not costs. ‘Fair value’ accounting would in principle lead to better insight into the risk profile of the financial entities than is presently the case, more so in the light of the requirement to move many relevant off-balance sheet items onto the balance sheet. Financial stability could benefit if shareholders, uninsured depositors and other debt holders are in a position to readily identify a deterioration in the safety and soundness of an entity. In fact, their reactions either by directly interfering in managerial choices or by exiting from the investment could put pressure on the entity’s management to take early corrective action.

3.11 ‘Fair value’ accounting is timely because it brings economic reality into the balance sheet. With growing concern on ‘going concern’ of entities, a balance sheet prepared on ‘fair value’ basis will provide more relevant information as compared to a balance sheet prepared on outdated historical cost.

3.12 ‘Fair value’ balance sheet is a better representation of the net worth of an entity’s financial position than compared to a historical model. ‘Fair value’ measure of assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial information. ‘Fair value’ can also be viewed as a better presentation of stewardship, as fair values are essential for determining performance ratios such as return on capital employed.

3.13 ‘Fair value’ of an asset or liability depends only on the characteristics of the asset or liability and not on the characteristics of the entity that holds the asset or liability or when it was acquired. ‘Fair value’ is a market-based measure that is not affected by factors specific to a particular entity; accordingly it represents an unbiased measurement that is consistent from period to period and across entities.

3.14 ‘Fair value’ is a solution to the accountant’s problem of income measurement: In accordance with the widely-accepted Hicksian definition of income is ‘a change in wealth – the change in fair value of net assets on the balance sheet yields income’. Hence, ‘fair value’ measure is to be preferred to the hundreds of rules underlying historical cost income. The issue is – how do we take control of the reported numbers out of the hands of corporate management? We do it by requiring that assets and liabilities be reported at ‘fair value’.

3.15 Whilst one could debate the use of fair valuation for non-financial asset and liabilities, there is little debate as regards valuation of financial assets and liabilities. The issue really is : how does one use historical cost to value stock options or derivatives ?

3.16 ‘Fair value’ seems to be the only basis for valuing financial assets and liabilities. FASB be-lieves:

3.17 In case there is a well-defined and liquid market, defining ‘fair value’ is not problematic. However, for illiquid assets or liabilities it may be necessary to use a model to derive ‘fair value’, such as one based on the present value of ‘future cash flows’. But model’s assumptions, such as the r relevant discount rate, may vary widely between in-stitutions and types of assets/liabilities and such variations raise questions about reliability. As a result, some opponents of ‘fair value’ suggest that:

3.18  The counter argument is that even if there is a degree of potential unreliability as to the values, they are still useful to decision-making, because they represent economic reality as opposed to an accounting ‘fiction’ in the form of historical cost. A ‘fair value’ based balance sheet is a better representation of the net worth of an entity than one based on historical cost.

4.1 Having considered the superiority of fair valuation over the historical model, now let’s look at the pitfalls of fair value. Clearly ‘fair value’ is not a panacea for all ills. At this point in time ‘fair value’ methodology is definitely not well established in IFRS or US GAAP, and the determination of fair value can be highly subjective. In the absence of any specific guidance, ‘fair value’ raises a number of issues, such as:

4.2 The term ‘Fair value’ implies active and liquid markets with knowledgeable and willing buyers and sellers and observable arm’s-length transactions – not values calculated on the basis of hypothetical markets, with hypothetical buyers and sellers.

4.3 ‘Fair value’ also increases the risk of misunderstanding on the part of existing or potential investors. ‘Fair value’ might be the realisable market value, but it will not necessarily equate to the market value of the entity because of the existence of internally generated goodwill or other intangible assets. It cannot be denied that ‘Fair value’ brings balance sheet value closer to the market value. However, using fair values for decision-making remains relatively difficult, but probably less difficult when compared to the historical model.

4.4 In the absence of market value, a surrogate has to be used by regarding a mathematical calculation of a hypothetical market price as a fair value. This is illustrated in the following ‘fair value hierarchy’ that has been developed by the US FASB and embraced by the IASB. This indicates the process that should follow for determining ‘fair value’ :

4.5 The reality is that a Level 3 subjective assessment will be required to measure ‘fair value’ in many situations. This will apply to intangible assets acquired in a business combination, unquoted equity securities, equity securities quoted on illiquid markets, derivatives, pension costs, provisions for share-based payments, asset revaluations, impairments and biological assets during the growth phase.

4.6 The fundamental question is whether such hypothetical amounts are sufficiently understandable, reliable, relevant and comparable for financial reporting.

1.    Do the users understand how hypothetical and subjective ‘fair value’ can be?

2.    Can valuations that are not independently verifiable be considered reliable?

3.    Is information that is not reliable, relevant in the world of financial reporting?

4.7 ‘Fair value’ measurement models have been developed for some contractual assets and liabilities especially financial instruments. There seem to be fewer prospects for developing reliable fair value measurement models for non-contractual assets that are inputs to revenue-generating processes – assets that do not generate cash flows by themselves, but contribute along with other inputs to a cash-generating process – can present significant fair value measurement problems when there are no observable market prices for identicalor similar assets, for example, an equipment that is configured for a specialised use. It could be concluded that realisable value in the marketplace is nothing beyond its value as scrap, or the market value of unspecialised equipment less estimated costs to restore to its unspecialised condition. This view presumes that the market does not attribute any value to use. This would be an unreasonable presumption.

4.8 The reliability of fair value estimates is de-pendent not only on how well a model replicates accepted market pricing processes, but also on the reliability of data inputs and assumptions that marketplace understands – for example – data inputs required by ‘accepted stock option’ pricing model includes the current price of the underlying stock, the volatility of that price, the effects of vesting provisions, and the risk-free interest rate for the expected life of the option. The market prices of certain of these inputs can be readily observed, for example, the risk-free inter-est rate can be derived from the price of government bonds and the current price of the underlying stock can be observed if it is traded in a market. The market’s measure of some other inputs may not be so readily determinable, for example, the effects of vesting provisions and the appropriate measure of volatility. Further, the measure of volatility on pricing an option is commonly based on past volatility, which may not be fully indicative of future volatility. Consistency of such data with market expectations requires careful evaluation in the context of the particular circumstances and disclosure of the basis of such data, underlying assumptions and the extent of measurement uncertainty. It may not be out of place to quote Warren Buffet, who feels that ‘marking to market’ has changed to ‘marking to a model’ but is actually ‘marking to myth’.

4.9 As many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are subjective making ‘fair’ valuation less reliable. Federal Reserve research shows that ‘fair value’ estimates for bank loans can vary greatly depending on the valuation inputs and methodology used.

4.10    Banking  regulators    have observed  that  minor  changes in the  assumptions in a pricing model can have a substantial impact  and reliability can be a significant concern. However, FASB feels  that reliability can  be  significantly enhanced  if market inputs are used whilst valuing.

However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue. Management’s use of judgment bias – whether intentional or unintentional in the valuation process, may result in inappropriate fair value also resulting in misstatement of earnings and capital. This is the case in the overvaluation of certain residual tranches in securitisations in recent years in the absence of active market. Significant write-downs of overstated asset valua-tions have resulted in the failure of a number of entities operating in the financial market.

4.11 It should be clear that the date and purpose of valuation is critical in establishing a ‘fair value’. A valuation determined at a particular point in time generally should not be relied upon for value on any other date. In the same vein, a valuation made for a particular purpose may not be appropriate for another purpose. Moreover, given the current state of the art, particularly with regard to credit risk models, reliability of financial statements could be negatively affected as fair values do not always convey precise information regarding an entity’s risk profile. Misjudgement can trigger overreaction, which can have a negative impact on the valuation of an entity.

4.12 We continue to read stories about earnings manipulation under the ‘historical cost’ model. The author believes that in the absence of reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements is greater. Moreover, valuations that are not based on observable market prices but on management judgments will be difficult to audit.

4.13 Volatility in earnings is another constant argument one hears against fair valuation.

1.    For assets and liabilities held to maturity, the volatility reflected in the financial statements is artificial and misleading as any deviations from cost will be gradually compensated during the life of the financial instrument, ‘pulling the value to par’ at maturity.

2.    An excessive reliance on fair values, including non-actively traded assets on illiquid secondary markets run the risk of embodying ‘artificial’ volatility, driven by: short-term fluctuations in financial market or caused by market imperfections or by inadequate de-velopment of valuation model.

4.14 The counter argument is that financial in-stitutions may have an incentive to take proactive measures in order to prevent this from occurring, by building additional reserves and thereby increas-ing their resilience in case certain binding finan-cial ratios are exceeded (e.g., capital requirements or ratios used in loan covenants that could trigger actions such as repayment).

4.15 Increased volatility is not necessarily a problem if investors correctly interpret the information disclosed. In particular, market analysts and institutional investors should try to extrapolate fair valuations from a variety of sources and mature financial markets would be in a position to appropriately interpret this increased volatility.

4.16 Implementation and maintenance of a fair value accounting system will cost time and resources. There may be other alternatives that may make more sense in a given situation. A case in point is one where biological assets are required to be fair valued by fAS 41. Other than questioning the need to fair value non-financial assets, the fact that biological assets are generally owned by small enterprises should not be ignored. These enterprises may find the whole process defeating, since fair value done at prohibitive cost may be completely useless for the purposes of decision making.

4.17 IAS 41 requires biological assets to be fair valued. IAS 41 met with severe criticism because many biological assets are simply not capable of reliable estimate of fair value. For example:

Take for instance, a colt which is kept as a potential breeding stock, grows into a fine stallion. The stallion starts winning race events and is also used in Bollywood films, as the stallion earns substantial amount for its owner from breeding and other services, the stallion gets older, his utility decreases. Eventually the stallion dies of old age and the carcass is used as pet food. At each stage in the life of the stallion, the ‘fair value’ would change significantly, but estimating the fair value would be extremely subjective and difficult. The issue is : if changes in fair value of fixed assets are not recognised in the income statement, then why should the treatment be different in the case of biological assets?

Vineyards and coffee and tea plantations have similar measurement issues. The relationship between the vines and coffee or tea plants and the land that they occupy is unique and integrated. The vine or plant itself has relatively little value. However, in conjunction with the land, they do have value. Determining the fair value for a vine-yard, coffee or tea plantation involves esti-mating production along with sales prices and costs for a number of years in the future, together with estimating a terminal value and the application of a discount rate to calcu-late the net present value – an enormously complex and subjective task. The value of the vines and plants would then have to be determined as a residual because it would be calculated by deducting the value of the un-improved land and the value of the infra-structure from the aggregate value. It is clear that the valuation in the above examples is based on subjective estimates and is open to substantial variability.

4.18 Pitfalls – of using ‘fair value’ for biological assets are:

4.19 Applying the ‘fair value’ option to the report-ing entity’s liabilities poses a particular problem, especially from a prudential point of view. As, under the fair value option, fair value measurement is not restricted to market developments (e.g., market interest rate fluctuations or changes in the exchange rate parities), but is all-encompassing, i.e., it also includes fluctuations caused by changes in the reporting entity’s credit rating – for example – a deterioration in the entity’s credit rating and the resultant devaluation of its own liabilities leads to an increase in its capital, for example, if an entity that has borrowed at 10%, credit worthiness goes down subsequently, and can now borrow only at 12%, it would record a fair value gain on the earlier loan reflecting the 2% gain on account of its own credit deterioration. From a prudential point of view, this is unacceptable.

4.20 In case of banks and financial institutions:

4.21 However, the flaw with the above argument is that:

4.22 The inadequacy of historical cost, transac-tion-based approach for dealing, in particular, with derivatives (which have little or no initial cost but can expose companies to very substantial financial risk) and diminutions in the value – impairments of assets, have encouraged standard-setters to espouse an asset/liability approach to recognition of income and a ‘fair value’ basis of measurement of assets and liabilities.

4.23 Although the recognition of unrealised gains and losses on financial assets is achieving wider acceptance, the IASB has not yet put forward any convincing arguments in favour of a ‘fair value’ model for non-financial assets. IAS 41 does not require the existence of active market for using fair value in case of biological assets. This approach is inconsistent with other international standards, for example – for valuing intangibles under IAS 38, the existence of an active market is a perquisite for using fair value.

5.1 The arguments for and against fair value accounting raise fundamental questions about core accounting issues, such as how performance should be measured, and the relative merits of the qualities of relevance versus reliability. Fair value accounting is a paradigm shift – it moves away from ‘historic focus’ to a ‘current perspective’ on value. However, the standard-setters now face a significant dilemma :

how can they continue to pursue their mark-to-model approach to asset/liability measurement and, at the same time, promul-gate accounting standards that will lead to a style of financial reporting that enables investorsto evaluatemanagement performance and assess enterprise value to make sound
investment decisions ?

5.2 The issues are:

5.3 The answer is :

5.4 The most interesting question in everyone’s mind is how long it will take for the full range of non-financial assets, and particularly internally generated goodwill, to be measured using ‘fair valuation’. That would make future balance sheet, a valuer’s balance sheet rather than an accountant’s balance sheet.

5.5 Using fair values to measure assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial statement information. These criteria are to be applied in the context of the primary objective of financial reporting, which is to aid investors and other users of financial statements in making economic decisions. The criteria include relevance, comparability, consistency, and timeliness. Fair values are relevant because they reflect present economic conditions, i.e., the conditions under which the users will make their decisions. Fair values are comparable because the fair value of any particular asset or liability depends only on the characteristics of the asset or liability, not the characteristics of the entity that holds the asset or liability or when it was acquired. Fair values enhance consistency because they reflect the same type of information in every period. Fair values are timely because they reflect changes in economic conditions when those conditions change. In addition, fair values can be viewed as fulfilling a stewardship role for financial reporting because the financial statements reflect the values of assets at the entity’s disposal. Such values are essential for determining performance ratios such as return on capital employed. The author would conclude by stating that despite its faults, ‘fair value’ is here for good and as the valuation models become more established in future accounting standards, many of the criticisms on fair valuation would disappear. If marking to market is a myth, then historical cost accounting is rather a mystery. A return to full historical model would be a retrograde step. Investors are definitely not seeking financial statements that have outdated information. Change to ‘fair value’ is a challenge to our profession and I am sure we will meet the challenge.

A client is always in need for innovative, different ideas
which will make them distinctive in comparison to their competitors’. In today’s
world, where the client has a strong in-house team, they would be very well
equipped to handle day-to-day and routine matters. Further, the in-house team is
also capable of providing the routine, conventional and a standard solution
which a normal professional organisation would give. In such a case, the client
would start thinking : Why should we hire an external professional
organisation when it is going to provide us the same solutions at a higher cost ?
Clients need more than just standard solutions for which it is important for a
professional organisation to innovate on a continuous basis. If the professional
organisation does not realise this fact, it may lose out on such client. Here
comes the need for innovation in providing services.

Innovation could be radical in nature i.e., a
different solution/idea by means of which the client is benefited tremendously.
The client could benefit in terms of savings of tax or in terms of economics of
the project. For example, a professional organisation may provide an out-of-box
solution by which the client saves service tax and the entire
economics/commercial feasibility of the project may change in favour of the
client. Such kind of innovation gives a huge advantage to the client and his
competitors may be totally outplaced, if they do not take measures before their
market position is completely lost. By providing such solutions, the
professional organisation gets loyalty from its clients and it ensures that it
stays ahead of its competitors.

Innovation could be proactive in nature. Proactive innovation
means proactively searching for solutions to problems of the client. It starts
with asking the client right questions, defining a problem or opportunity which
the client is facing. The second step would be to gather or collate information
from various sources (including the client himself) to gain more knowledge of
the facts. This is the most important process of ‘creative’ thinking whereby new
ideas are generated by analysing the information. Thus, in this manner a new
solution is developed which will solve the problem on hand and adhere to client
needs. Thus, innovation in services cannot take place overnight. It is normally
a steady, hard-headed response to client needs and not the accidental insight or
idea. However, proactive thinking also means that identifying a problem which
the client is facing where the client is not aware of the potential problem and
the impact of such problem. In such a case, the professional organisation has to
proactively approach the client and has to warn him of the potential problem and
provide him an appropriate solution, without thinking whether the client pays
its fees for such advice or not. This pro-activeness would delight the client.

Sometimes it is possible that the problem which the client is
facing is being faced by all the companies which are in the client’s business.
In such a case, a combined solution can be sought by asking the client to join
hands with its competitors and make a joint representation to the government or
any other regulatory authority. This will ensure that the client is benefited,
as the representation will get more importance as it is made by all the players
in that particular industry and chances of it getting approved are enhanced.
Further, the client would suffer a lower cost as the cost is shared by all the
professional organisations and the client is also benefited as it comes into
limelight in front of all the industry players and would certainly generate
income from them in future.

Innovation could also be in the nature of incremental change.
Incremental change can be in the form of generating good, new ideas to support
existing services, service delivery or processes. In other words, a better way
or method of doing the same thing in a more efficient manner. Certainly, one
may think, how does incremental change benefit the client ? This type of
innovation certainly improves efficiency of the professional organisation and
ensures that the deliverables are faster. This gives the professional
organisation a competitive advantage and also leads to client satisfaction. Some
of the ways in which efficiency can be ensured is by providing short, clear and
practical advice. It should be remembered that client normally wants a quick
advice. Therefore, at times it is better to talk over the phone and discuss the
matter rather than sending out long emails which may take good amount of time.
The conclusion of such teleconference could always be circulated later.

Professional organisations can no longer remain static or arrogant as in the past, because the clients have become more informed and more demanding in these times of information boom. They now question the opinions, the approach and the manner and get satisfied only with a thorough response. Gone are the days when professional organisations were rewarded for simply providing excellent services. Clients also want their consultants to help them network and improve their businesses. They want services to be efficient, cost-effective, and technologically advanced. The professional organisation cannot take the client for granted and has to realise that the client is always in need for new and distinctive ideas. The professional organisation has to ensure that the client is satisfied with its service. Hence, it has to be innovative at all times.

How can the professional organisation innovate in order to provide client satisfaction ?

A professional organisation can innovate in a number of ways. In my opinion, the following are some of the ways in which a professional organisation can innovate and ensure client satisfaction:

Clearly, fabulously successful enterprises such as Gillette razors and Coca-Cola have been applying innovation at the point where it matters most – the client’s/customer’s changing needs. In other words, innovation has to be something which has the end-objective of keeping the client happy. Generating ideas and being innovative are important contributors to business success.

A classic example of innovation could be a trans-formation of an enterprise which is willing to innovate and chunk old traditional ideas e.g., ICICI Bank and HDFC Bank. The banking system in India as recently as in late 1990s was stuck in the rut of big and static PSU banks, the whole of the banking sector was ailing from syndrome of ‘Over-branched but underserviced’. In this scenario, these banks emerged and changed the entire landscape. Keeping the customer service as its prime focus, they embraced technology as its main aid and kept on innovating services to meet client satisfaction. The result is for everyone to marvel. This is a classic example of turnaround of the company by keeping the clients/customers happy.
 
To add value to our conventional practice of audit we can innovate, for example whilst reviewing:

Another area is assisting and advising clients in the discharge of ‘social responsibility’. It is an area where we can innovate and be a catalyst. Let us accept that charity in today’s environment is big business. Let us assist business in carrying out philanthropic activities which are in the interest of business.

In my view, innovation is the need of the day and organisations including professional organisations should encourage innovations and have to ensure that their clients are continuously fed with more and more innovative solutions. IBM, for instance, has recently run a series of television commercials on innovation. The theme is the need to innovate because: “in today’s world your new idea on Monday is a commodity on Wednesday … “

I would conclude  by stating:

“Innovate to survive by anticipating need, nay, creating need for those whom we serve.”

1.1 Works Contracts — Species of Composite Contracts :

Composite contracts involving both the supply of materials
and rendering of services (in reasonably dominant proportions) are known as
works contracts. A turnkey contract of the nature referred to above is a good
example of a works contract. In a works contract, there is a transfer of
materials from the contractor to the employer/contractee, however, the said
transfer is not by means of sale.

In a works contract, the contractor agrees to perform some
work on the client’s property (may be moveable or immoveable). The performance
of work also involves the use of some materials of the contractor. As the
contractor uses these materials to perform the work, the materials get attached
to the property of the client in such a fashion that such contractor’s materials
can no longer be removed without substantial damage either to the contractor’s
materials or the contractee’s property. Since the property which is the subject
matter of the work belongs to the client, the ownership of the materials so
attached on the property passes on to the client albeit in an indirect fashion.

1.2 Accretion :

Consider the case of a building contractor who constructs a
building on the land of the client using his owned bricks, sand, cement, etc.
Till the stage he applies the cement on the land and lays a brick on it, the
cement and brick belongs to the contractor. But once the cement paste and the
brick are applied on the land, these ingredients fasten themselves to the land.
It is then not possible or viable to remove the cement or brick from the land
(without fundamental damage). Since the land belongs to the contractee, the
ownership in the cement and brick gets transferred to the contractee by
inference and not by way of sale. This process of the contractor’s materials
getting embedded in the client’s immoveable property is referred to as the
transfer of ownership in goods through the process of accretion.

1.3 Accession :

Consider another example of a garage undertaking to paint the
car of its client. Similar to the earlier example, till the stage the garage
applies the paint on the car, the paint belong to the garage. But once the paint
is applied on the car, the liquid paint gets attached on the metal of the car.
It is then not possible to remove the paint without fundamental damage. Since
the car belongs to the client, the ownership in the paint also gets transferred
to the client by inference. This process of the contractor’s materials getting
embedded in the client’s moveable property is referred to as the transfer of
ownership in goods through the process of accession.

1.4 Blending :

One more situation of works contract could be a case where
multiple moveable products owned by the contractor are ‘blended’ together to
create a new moveable product which is non-marketable in nature. Consider the
case of a printer who uses paper and ink to print cheque books for its client
bank.

In this case, the transaction cannot constitute a sale
because cheque books are not marketable and there-fore are not goods. However,
the properties in the paper and the ink have passed on to the bank the moment
the printer blended these two moveable products. Thus, there is a transfer of
the ownership in goods through the process of blending.

2. Nature of Indirect Taxes and applicability to Composite Contracts :

At this juncture, it may be relevant to broadly classify the
indirect taxes based on the nature of the taxes. At one end of the spectrum are
duties on goods like customs duties and excise duties which are levied on
specified activities i.e., the activity of import/export of goods or the
manufacture of goods. Since the levy of duty is on an activity and not on a
transaction, it is apparent that the duty is attracted irrespective of whether
the product constitutes an end in itself or a means to an end.

At the other end of the spectrum are taxes like sales tax
(VAT) and service tax which are levied on specified transactions i.e.,
the transaction of sale of goods or the provision of services. Since the levy of
the tax is on a transaction, one has to look at a transaction. A transaction is
the cake itself (i.e., the end) and not the icing on the cake (i.e.,
the means to an end). This therefore suggests that for taxing the transaction,
one looks at the tax implications on the cake and not on the icing !

3. Composite Contracts — Judicial Thinking :

Before proceeding any further, it may be relevant to look at
the judicial thought process on this aspect.

S. 145 of the Act provides that income chargeable under the
head ‘Profits and gains of business or profession’ or ‘Income from other
sources’ be computed in accordance with either cash or mercantile system of
accounting regularly employed by the taxpayer. It empowers the Central
Government to notify accounting standards to be followed for computing such
profits. Pursuant to the said powers, the Central Government has notified two
accounting standards (AS), one of which needs to be mentioned here. The notified
AS defines ‘Accounting Policies’ to mean the specific accounting principles and
the methods of applying those principles adopted by the assessee in the
preparation and presentation of financial statements. It further provides that
the Accounting Policies adopted by an assessee should be such so as to represent
a true and fair view of the state of affairs of the business, profession or
vocation in the financial statements prepared and presented on the basis of such
accounting policies. For this purpose, the major considerations governing the
selection and application of accounting policies are the following, namely :

1.2 Tax laws world over are complex, but the Indian
Income-tax Act has the unique distinction of being amended every year, often
retroactively and at times the law is amended even before it has become
applicable. This has resulted in an already complex law being made almost
incomprehensible.

1.3 Our tax laws live up to Senator Spark M. Matsunaga’s
statement :