As the government readies to defer enforcing Accounting Standard-11, Kaushik Dutta and Kshama V Kaushik point to other flaws - Indian GAAP allows qualified accounts, for instance, while the SEC doesn't
Every financial scandal leads to intense debate on how to improve the existing mechanisms for providing better safeguards. The Sarbanes Oxley Act, Clause 49, Kings Report and various insider-trading rules are all the direct result of major economic debacles. It’s safe to assume the underlying causes of the current global credit crisis or the chinks exposed by the Madoff fraud will result in more changes or review of existing regulations. The turmoil in India, caused by events at Satyam, certainly warrants a systemic review of all components of the economic and corporate system. However, if legislation is brought about as a reaction to a specific debacle or even the regulators’ need to be seen to be acting, it will create sub-optimal solutions. Regulations need to be defined in consultation with a large group of stakeholders so that it facilitates business operations and helps in the growth of a robust economy.
India’s Generally Accepted Accounting Principles (GAAP)
Since Indian GAAP allows qualifications to an audit report, it is not uncommon to find companies with heavily-qualified accounts declaring dividends or raising capital. In some cases, a company’s management uses a qualified audit report for non-provision of expenses in order to maintain an accepted level of earnings or to avoid being classified as a sick company due to book losses over the threshold.
The Securities and Exchange Commission (SEC) of the US does not accept any audit report which is qualified for non-compliance of GAAP for listed companies registered with it. The SEC requires companies to remove such qualification by making necessary adjustments to their financial results.
International Financial Reporting Standards (IFRS) defines compliance with IFRS as the first annual financial systems in which an entity adopts IFRS by an explicit and an unreserved statement of compliance. Explicit and unreserved compliance with GAAP eliminates the possibility of any qualified compliance.
We need to define what constitutes compliance with Indian GAAP. This compliance needs to be unequivocal and explicit. The responsibility to comply with GAAP remains with the management while the auditors express an opinion on such compliance. Our laws need to provide that conditional and selective compliance of GAAP, including accounting standards, is not good enough to discharge the obligations of management for providing financial results in a true and fair manner. Global standards require that our tolerance to non-compliance of GAAP should be minimal.
Independent directors
The role of independent directors has come under scrutiny because of the Satyam fiasco and in times to come this group will remain in the spotlight. It is important to clearly define the expectations from and the duties of an independent director and how much reliance s/he can place on management disclosures while taking decisions. By the very definition, an independent director is independent of management but has few resources at his/her command to make independent assessments of topics under consideration. S/he cannot reasonably be expected to have more information than the management from an annual average of six meetings.
Likewise, there must be rational expectations of the roles played by other constituents. Roles and responsibilities, particularly of auditors and regulators, must also be clearly defined.
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Importantly, in case any shortcomings are found in the execution of these responsibilities, the fallout must be contained to individuals responsible rather than pulling down companies or institutions, unless they represent a systemic failure of the institution to respond to these risks of failure.
The quarterly demon
The race to provide quarter-on-quarter guidance and to announce results by the second week of the month following the end of the quarter creates huge pressure on the company, especially the accounting and finance departments, and may result in some skimming over facts. Ever-tightening deadlines to keep up with investor or analyst pressure leaves very little time for auditors or the company to follow a robust process of checks. This artificial pressure is not good for any stakeholder in the medium- to long-term, besides steadily compromising on quality. Secondly, the current rules require quarterly comparisons (of corresponding previous years) which limits the usability of information in today’s dynamic and changing business environment. Companies need to provide more sequential-quarter comparisons so that trends can be better analysed by retail investors.
Internal processes
Since 2005, all listed companies need to have key processes over financial reporting documented and then tested for their efficacy. However, over a period of time, the rigour of such checks and testing fades out and its relative importance from the key management perspective gets relegated to matters of routine.
Given the fact that the economy is in a downturn, it is imperative that all key reporting systems are evaluated again for their relative risks. The overall comfort of the management assertion through the CEO and CFO certification under Clause 49, defining the adequacy and efficacy of internal controls over financial reporting is greatly enhanced when they are made after due care and diligence.
The auditors also need to review relevant key processes for their reports under the Companies Act on internal controls in certain defined areas.
India is a relatively new entrant to the powerful and sometimes ruthless world of capital markets. Even newer is the concept of financial fraud using the levers of capital markets. Despite the most stringent rules and punishments (along with high conviction rate), developed economies have not found effective ways to prevent frauds altogether because frauds will occur as long as human greed exists. There are many people who are scared of the capacity of capital markets to cause mayhem and inevitably there are loud cries about more regulatory and government control, which is a throwback to a socialist era. But India has already walked down that path and moved towards integrating with the global economy through capital markets. The high GDP growth rate of the past few years bears testimony to the success of this economic philosophy. What the country needs now is not more regulation or more control, but improvement and better administration of existing checks and balances.
Kaushik Dutta is National leader IFRS practice, PricewaterhouseCoopers, Kshama V Kaushik is Managing Partner of Governance Matrix
They are co-authors of ‘Corporate Governance: Myth to Reality’, published by LexisNexis Butterworths