Financial reporting: Vision for future

ACCOUNTANCY

In November 2006, CEOs of the six largest international audit networks (Pricewaterhouse Coopers, KPMG, Grant Thornton, BDO, Deloitte, and Ernst & Young) issued a joint paper entitled 'Global Capital Markets and the Global Economy: A Vision from CEOs of the International Audit Networks'.

The paper recommends that in the short term, consistency across nations in business reporting standards, auditing standards, and in the enforcement of auditing standards must be ensured. In the longer run, it foresees a change in the current systems of reporting and auditing company information towards the public release of more non-financial information (some of which may be industry specific), customised to the user and accessed far more frequently than is currently done.

The paper observes that "complex rules must be resisted and withdrawn. Today's rules can produce financial statements that virtually no one understands. Standards need to be principles-based."

This perception, that standards should be principles-based, is not new. One of the key concerns raised by US accounting scandals like Enron was that US accounting standards had become 'rules-based', filled with specific details in an attempt to address as many potential contingencies as possible. This made standards longer and more complex, and led to arbitrary criteria for accounting treatments that allow companies to structure transactions to circumvent unfavourable reporting. Also, many standards specified so-called 'bright-line' accounting rules which made the choice of treatment depend on percentage tests. For example, the US GAAP requires consolidation of financial statements where the investor holds more than 50 per cent of voting rights in the investee company. This shifted the goal of professional judgement from consideration of the best accounting treatment to the goal to achieve technical compliance.

An example of the complexity of US GAAP is the GAAP on lease accounting. US GAAP related to lease accounting is addressed in 20 Statements, 9 Financial Accounting Standards Board (FASB) Interpretations, 10 Technical Bulletins, and 39 Emerging Issues Task Force (EITF) Abstracts. The depth of GAAP coverage of leases is characteristic of the rules-based accounting system in the US. One of the main disadvantages of a rules-based accounting standard like this is that even if the management and auditors do not intend to evade the objectives of the standard, they are forced to take the 'check-the-box' approach ignoring the overriding principle that financial statements should present a 'true and fair view'. Therefore, the Sarbanes-Oxley Act of 2002, which was enacted to regain the confidence of investors in corporate reporting and corporate governance after a spate of scandals in US, required the Securities and Exchange Commission (SEC) to examine the feasibility of a principles-based accounting system.

While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the implementor is directed back to the principles. Thus, principles-based accounting standards provide the flexibility that is needed to apply the standard in different situations and different types of businesses.

Often, in an effort to achieve comparability, principles-based accounting standards get transformed into rule-based accounting standards. US GAAP started as principles-based standards but over time has become rules-based standards. Standard setters must guard against this and strike a balance between comparability and flexibility. International Financial Reporting Standards (IFRS) and Indian Accounting Standards (IAS) are principles-based accounting standards.

The process of preparing a company's financial statements essentially involves a translation of economic reality into an accounting framework that is defined by a set of standards. In preparing and attesting to a company's financial statements, management and auditors have to interpret standards. This is more so when they have to apply a principles-based standard. Accounting professionals make an informed judgement to apply an accounting standard in a manner that best fulfils the objective of the standard and thereby best captures the underlying economic reality. Therefore, enforcement of principle-based accounting standards requires greater discipline by the corporate management and the accounting profession.

In India, the implementation of accounting standards is weak and there is scope for improvement. The World Bank's report on the Observance of Standards and Codes (ROSC) on accounting and auditing observes: "Indian accounting and auditing standards are developed on the basis of international standards; and the country has many accountant and auditors who are highly skilled and capable of providing international-standard services. However, in order to further improve the quality of corporate financial reporting in India, there is a need to improve the institutional framework and take steps for enhancing compliance with the applicable standards and rules."

The Institute of Chartered Accountants of India (ICAI) and regulators should pay attention to above observations and should strengthen the institutional mechanisms to improve implementation of standards.

The observation of the paper issued by six largest audit networks that complex rules must be resisted and withdrawn, expresses a concern shared by many stakeholders to financial statements. Yet, there are no easy solutions. Accounting for complex transactions is likely to be complex. For example, accounting for financial instruments cannot be as simple as accounting for inventory or property, plant and equipment. However, the observation shows the way that standard setters should take in formulating new accounting standards and in reviewing existing standards with an eye towards simplification.

The third observation of the paper about disclosure of non-finance information also demands serious consideration. Disclosure of non-finance information makes financial statements more transparent and useful. However, companies usually resist full disclosure of financial and non-financial information. They argue that full disclosure affects competitive advantage adversely, which in turn hurts the interest of investors. Companies also resist disclosure of information that may adversely affect the valuation of the company.

It will hence be a bold step to mandate disclosure of non-financial information.

The critical question is what kinds of non-financial data public companies should be reporting. As observed by the report, "investors and other stakeholders need to get engaged and weigh-in or change will be marginal at best." Also, standard-setters will have to ensure that they are able to protect the interest of different stakeholders. While there is no hard evidence, it is believed that in past the ICAI has indeed succumbed to lobbying and delayed issuance or implementation of new standards.

Can India lead the transition to the new model of corporate reporting?

(The writer is professor of finance and control at IIMC)