YESTERYEAR practices and solutions shall not serve a different today of the 21st century. Wide-ranging changes are called for across the entire spectrum of accountancy and auditing like the balance sheet, profit and loss account, good governance regulations, auditing standards and practices and measures to assure as far as feasible auditors’ independence. The extant balance sheet and profit and loss account are, by and large, an inheritance from 19th century Victorian age and call for a radical shift — just as a plough horse cannot gallop on a racetrack, the two do not size up to the 21st century needs.
Balance sheet: The extant balance sheet is an amalgam of great array of options e.g., accounting policies and estimates, available to management. “What a balance sheet presents is one range out of many others that the management has opted”, as pointed out by the chairman, UK Auditing Practices Board (APB). When such options and assumptions are changed, APB says, the figures change: “deliberate or inadvertent biased judgment or an inappropriate decision may result in misstating or misleading information.”
The Canadian Commission on Public Expectation of Audits, 1988 had recommended elimination of alternatives provided by the standards and “if support cannot be mustered for the elimination of alternatives accounting standards should require disclosure that the choice of policies in this area is arbitrary and the disclosure should indicate the accounting result that would have been obtained by using the alternative. When disclosure of the result in quantitative terms would be impractical or excessively costly, the indication may be in approximate or general terms (at a minimum stating whether the alternative is more or less conservative than that actually adopted).
As regards valuations and estimates, the Commission recommended that there was a need for better guidance with respect to disclosure of the bases used in making accounting estimates and the possible range in the valuation figures that could have resulted within the exercise of reasonable judgment. Harvey Pitt, when he was Chairman of the US SEC, had suggested that “Light should be shed on the processes of calculation that lead to the numbers in the financial statements, the five assumptions that make the biggest difference be identified, and how the numbers would look were different assumptions made shown.”
New look balance sheet: Baruch Lev, Professor of accounting and finance at the New York University Stern School of Business, has suggested for an entirely fresh architecture of the balance sheet. “The balance sheet should be divided into two parts: one “core” and the other “satellite”, he proposes. The core part should have the most reliable numbers, or the ones that rely the least on estimates—for instance, cash flow, and perhaps property, while satellite part should contain fair-value numbers and intangible assets, as well as other items. The company, he has suggested, should be obliged to state in its annual report what percentage of its numbers derived from estimates and what portions were verifiable facts. In the accounts for the next period, the company must report in detail how well its estimates had measured up to reality. This would put things in proper perspective in the long run as managers would not be able to get away with repeated big misses.
Profit-loss account: Pitt said, “there is no true number in accounting”; the companies and their auditors pretend when they work out a single profit figure and a single net-assets number. “The truth is that accountants do not know exactly how much money a company has made, nor exactly how much it is worth at any one moment. Realistically, the best they can hope for is a range—“X corporation made somewhere between 600m and 800m”—depending on, for instance, what assumption is made about the likelihood that its customers will pay all the money that they owe,” points The UK ‘Economist’.
Holgate, a partner in Price Waterhouse Coopers (PWC), observes points, “presenting ranges of profits according to different assumptions would be much more realistic than the extant practice (of presenting one figure).”
New look Profit and Loss Account: The solution, says Paul Pacter, director at Deloitte in Hong Kong, is to redesign the income statement. Both the International Accounting Standards Board and US’s Financial Accounting Standards Board in collaboration with the UK Accounting Standards Board are currently engaged in creating a new way of presenting earnings information. Initial reports have suggested a three-column income statement designed to break earnings down into ongoing or underlying income, exceptional items, and then unrealised gains and losses resulting from changes to fair value on the balance sheet.
As a result of fair value accounting “there must be a complete overhaul of reporting,” argues Pearl Tan, accounting professor at Nanyang Business School in Singapore, Tan calls for more prospectus-style reporting, detailing the estimates and assumptions used to calculate fair values, and also for greater use of range reporting rather than single-point estimates, along with sensitivity and scenario analysis.
Others have suggested that the profit and loss account should be presented in matrix form of three columns; one column showing gains and losses from changes in fair value arrived at by using different accounting assumptions, another old-fashioned costs and revenues, and the last the total of the two.
Company annual report: Directors’ report, we all know, is a snapshot. Developed countres require directors to complement and supplement financial statements by forward-looking events and trends, including future plans, facts and events, probabilities, as well as risks and opportunities including even non-financial information through Management Discussion and Analysis. The OECD reckons MD&A as a feature of good governance.
Clearly, it should be mandated as part of good governance in Pakistan as well. In any case, it is inevitable. The project team of International Accounting Standards Board (IASB), is already drafting ‘management commentary’ along the above-indicated parameters. When implemented by IASB, Pakistan as its member shall need to go along with it.
Directions of Audit: All of the examples of reporting failure demonstrate a failure to act ethically by at least some of the participants who should have known and done better: “The list is lengthy: misleading auditors, auditors looking the other way, disguising transactions, withholding information, providing unbalanced advice, abuse of trust and misusing insider information.” (International Federation of Accountants (IFAC) Task Force report, 2003)”.
To win back the lost credibility, the profession needs to prove and reprove by acts and deeds its credentials for trust.
Consultancy: Though scope for consultancy business has been drastically curtailed but it is yet rattling investors. The Financial Times (UK) survey shows Big Four firms made more money during year 2004 from the provision of other services to same large audit clients than from the actual audits. In one instance, the consultancy fee was nine times of the audit fee.
‘The situation demands more homework by regulators. For example, the US Public Company Accounting Oversight Board (PCAOB) has banned tax service that demands representing before a tax court or in any other court of law because it impairs auditors’ independence.
Internal control: The epicenter for repeated and, as of this writing, ongoing revelation of corporate wrongdoing lies, as we all know, in the failure of internal controls.
“Good internal control is one of the most effective deterrents to fraud,” observes William McDonough, PCAOB Chairman. Strong controls are vital to high quality financial reporting and essential to timely analysis.” “There is no way to measure how many reporting failures will be averted and how many investment dollars will be saved because of increased attention to effective internal control systems.
All participants in the financial reporting system-investors, management, audit committees, auditors, regulators- must make the development of and adherence to these systems a priority”. (Donald T Nicolaisen, Chief Accountant, SEC.
Auditors and regulators: Pinning of expectations of high performance is one thing; providing performance environment conducive to such high hopes is another. Research in the US etc has revealed auditor-company relationship being strained due to reporting on internal control etc. They need greater support in their position vis-à-vis the company as paymaster.
Public Company Accounting Oversight Board’s (PCAOB) Charles D. Niemeier points out that “there are plenty of times [companies] wanted to change auditors because they weren’t being given the answer they wanted.” He has warned that the newly created regulator will launch an investigation whenever companies fire their auditors. Whenever you see a change in auditor, the PCAOB is going to look into it,” he told a panel at the Directors’ Institute on Corporate Governance.
The US SEC has expressed its desire for companies to make greater voluntary disclosure about why they part ways with their external auditors. “Providing investors in plain English the real story behind why there is a change in auditors I think will alert investors earlier on to potential problems and concerns,” observed former SEC chief accountant Lynn Turner. “It’s important for investors to understand which are the good changes, which are the bad changes, and which are absolutely ugly and are going to raise a large red flag for investors – and they need to know that at the earliest possible date,” he said.
The UK now makes the person who knowingly or recklessly makes a statement to an auditor that is misleading, false or deceptive in a material particular guilty of an offence and to liable to imprisonment or fine, or both. (Section 389B- Companies (Audit, Investigations and Community Enterprise Bill). It requires directors to state in their report that there is no relevant audit information of which the company’s auditors are unaware, and he has taken all the steps that he ought to have taken as director in order to make himself aware of any relevant audit information and to establish that the company’s auditors are aware of that information.
Institutional investors: Investment corporations, e.g., ICP and NIT, and mutual funds own shares as fiduciary of individual investors. They are now the major players in the money market, which shall increase manifold. They have to(play active role in monitoring corporate performance and in conveying concerns on behalf of individual investors to the board by voting or withholding vote at the annual general meeting. It is imperative therefore to lay down some rules of conduct for them.
The Securities and Exchange Commission of Pakistan as a measure of good governance should make it obligatory for such institutional investors to disclose their overall corporate governance and voting policies with respect to their investments, including the procedures that they have in place for deciding on the use of their voting rights and as fiduciary should disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights regarding their investments.
