Put focus on building capabilities

ACCOUNTANCY

Can accountants be replaced by a computer program which has all the accounting standards fed into it and which is directly connected to a firm's management information system?

That seems unlikely to happen in the near future, one of the biggest reasons being that many of the figures that enter into financial statements are not mechanical measurements.

Rather, they are the best estimates of the management based on its knowledge of the business. Just to take a couple of examples: Depreciation can be calculated based only on the management's estimate of the useful life and residual value of assets; actuaries may be hired by a firm to estimate its pension liabilities but they can work only on the basis of the management's best estimate of demographic variables like the average retention period of employees, and the compensation of employees at the time of leaving the firm.

When you become aware of the great extent to which figures in financial statements depend on the management's estimates, it seems surprising that these statements are trusted at all.

You realise immediately that it is possible to 'manage' earnings to a large extent, even while sticking to the principles of GAAP. And management has not just the opportunity to 'manage' earnings, it also has the motivation, since earning figures and ratios form the basis of investors' decision and debt covenants imposed by creditors.

What, then, makes financial statements trustworthy? It is the condition that the estimates provided by the management be based on evidence rather than being arbitrary. The responsibility of audit is to ensure that this is so. Financial statements published by companies must be accompanied by an audit report.

The auditor should not be in material disagreement with the management's estimates and accounting policy. If he is in material disagreement with the management and concludes that financial statements are misleading or incomplete in nature, he issues an adverse opinion.

A company cannot afford to have an adverse audit opinion. An adverse audit opinion gives the signal that figures in financial statements are not reliable. In a qualified audit report, the auditor asserts that the financial statements present a true and fair view 'subject to' or 'except for' the effects of the matters to which the qualification relates.

For example, the audit report may state that the profit and loss account gives a true and fair view of the profit/loss for the period subject to inadequate provision for expenses that the company will be required to incur to meet commitments under the product warranty. The auditor mentions his estimate of the deviation due to this inadequate provisioning.

An audit may also lead to a disclaimer of opinion if the auditor has not been able to obtain sufficient audit evidence and is, accordingly, unable to express an opinion on the financial statements.

In fact, every company wants to have an unqualified or clean audit report. It is because the certification by the auditor that financial statements provide true and fair view of the financial position and profit/loss of the company adds creditability to the information provided in financial statements.

Though legally it is the shareholders who appoint the auditor, in practice, the auditor is appointed by the incumbent management. But that does not dilute the auditor's accountability. He is accountable to shareholders and other users of financial statements, who rely on the competence, independence and integrity of the auditor.

A clean audit report provides reasonable assurance that a set of financial statements provide a true and fair view and that they are free from material error or fraud. However, much of the evidence available to the auditor is persuasive rather than conclusive in nature. Auditors look for reasonable assurance, not absolute certainty.

Moreover, constraints of time and resources mean that a comprehensive examination of all potential evidence is not feasible and auditors must use sampling, summary statistics and tests. Testing does not guarantee that all material mis-statements or fraud will be detected.

Similarly, the auditor applies judgement in forming opinion which may not be correct in all situations. Therefore, audit failure cannot be ruled out.

Auditing and assurance standard (AAS) is an important quality assurance tool. In India, the Institute of Chartered Accountants of India (ICAI) regulates the auditing profession.

So far it has issued 35 AASs. Standards, developed and promulgated by ICAI, are in conformity with international standards issued by the International Auditing and Assurance Standard Board (IAASB) established by International Federation of Accountants (IFAC). IFAC works with 157 members and associates in 123 countries and jurisdictions to protect public interest by encouraging high quality practices in accounting.

AASs only reduce the risk of an audit failure, but cannot eliminate it. The risk of an audit failure increases with the increase in the complexity of the business model and increase in the uncertainty surrounding the business. Auditors charge a premium for a higher risk of audit failure.

Empirical researches show that there is a positive correlation between audit fees and capital market measures of opacity. Similarly, companies that wish to signal greater transparency pay more for a higher quality audit and effectively purchase auditor's reputational capital.

Earlier, brand building by auditors was discouraged. But in a competitive and dynamic business environment, companies adopt complex business models. This implies that only those audit firms which can build capabilities and reputation will find opportunities to grow.

According to a report released by the Government Accounting Office of the US, the 'Big Four' accounting firms audit 98 per cent of the US companies with an annual revenue over $ 1 billion. It also reported that large public companies are still hesitant to go to a mid-size audit firm.

At the moment, the Indian accounting profession is dominated by small firms. Very few Indian firms have been able to establish a global presence and reputation.

Therefore, recognition of the Indian CA qualification can, by itself, bring very little gains to Indian accounting firms. It is doubtful whether even small-size and medium-size companies in other countries will use the services of Indian accounting firms.

Globalisation of audit services can be deferred but not avoided. Indian audit firms should focus on building capabilities and reputation. Tie ups with international firms cannot be the only strategy.