Wide-ranging changes have been made in 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 ensure as far as feasible auditors' independence. The balance sheet and profit-and-loss account are, by and large, an inheritance from the 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 eg, 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 option and assumption is changed, the figures change: "deliberate or inadvertent biased judgement or an inappropriate decision may result in misstating or misleading information." (UK Auditing Practices Board's Ethical Standard 1, Integrity, Objectivity and Independence, October, 2004).
The Canadian Institute of Chartered Accountant's Task Force constituted in 1998 to formulate policies concerning future directions of accounting standards had included as background paper report of Commission on Public's Expectations of Audits (1988).
The Commission 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 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). (Recommendation 8): 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. (Recommendation 16).
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."
NEW LOOK BALANCE SHEET: Baruch Lev, Professor of Accounting and Finance at the New York University's Stern School of Business, has suggested 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 was 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 upto 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.
THE PROFIT AND 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 'Economist'.
Holgate, not a partner, Pricewaterhousecoopers (PWC), points out "presenting ranges of profits according to different assumptions would be much more realistic than the extant practice (of presenting one figure)."
The historical cost based accounting would be history in a short while. The UK has already adopted fair value accounting and the International Accounting Standards Board is in the process of putting in place a standard on it, which should render one figure profit and loss more detrimental to the company.
NEW LOOK PROFIT AND LOSS ACCOUNT: The solution, according to Paul Pacter, director at Deloitte in Hong Kong and the original author of IAS 39, 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 a 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'S ANNUAL REPORT: Directors' report, we all know, is a snapshot. Australia, Canada, France, Germany, Hong Kong, Japan, Malaysia, Netherlands, New Zealand, South Africa, UK, and USA 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 (MD&A). The OECD reckons MD&A as a feature of good governance. (OECD Principles of Corporate 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) comprising representatives from national standard setters from New Zealand, Canada, Germany and the UK Accounting Standards Board 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 misuse of insider information." (International Federation of Accountants (IFAC) Task Force report, "Rebuilding public confidence in financial reporting" cited in Trust = confidence in the truth, Peter Williams, Financial Diretor, 29 September 2003.) 'Like it or not, business (of audit) got carried away with itself,' says Mike Rake, Chairman, KPMG. (Interview: Mike Rake, chairman, KPMG international, Damian Wild, Accountancy, 6 August 2004).
"A lot of the audit changes were [prompted by] competitive proposals based on pricing decisions by management and as a profession we allowed that to happen," says Ellen Masterson, global head of audit methodology at PricewaterhouseCoopers (PWC), the biggest of the four audit firms. Its Vice Chairman, John O'Connor, concedes "biggest mistake during the past few years was that it simply lost sight of the value of its core audit service-We had under invested in some of our services, including audit."(They might be giants: How audits must change, Kris Frieswick, 1 July 2003).
To win back the lost credibility, the profession needs to prove and reprove by acts and deeds its credentials for trust.
CONSULTANCY: Though the scope for consultancy business has been drastically curtailed it is yet rattling investors. The Financial Times 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. (Bob Reynolds, Non-audit fees still high in UK, rattling investors, 11 October 2004, Thomson Media Inc). In one instance, the consultancy fee was nine times of the audit fee.
The situation demands more homework by regulators. Eg, 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. (Briefing Paper, Auditor Independence and Tax Services Roundtable, July 2004, PCAOB); the UK Auditing Practices Board's Ethical Standard 5, effective 15 December 2004, as well specifically prohibits auditors' taking tax services which should involve acting as an advocate before a first level of Tax court where a binding determination of tax law (as opposed to findings of fact) is made and to more authoritative bodies. (Paragraph 73 read with note 5 thereto).
INTERNAL CONTROL: The epicentre 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, October 7, 2004).
Note 9 to IAASB's new auditors report effective from or after 31 December 2006 candidly suggests the impending shift: the note even suggests in advance the words that should be used when reporting is mandatory: "In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances."
Internal control is a comprehensive term, eg, "A company needs to have a certain amount of [in-house] knowledge to determine the appropriate accounting issues," says Richard Steinberg, formerly leader of PWC's governance practice.
BDO in the case of Advanced Materials Group Inc reported as control weakness the absence of a full-time CFO and lack of staff expertise; "Insufficient personnel in the corporate accounting department with sufficient knowledge...of US GAAP" was reported as control weakness by PWC in the case of insurance corporation AXA."
We don't seem to have learnt our lessons, however. Good governance regulations do not add anything of substance in this behalf - the regulations only make directors' implicit responsibility regarding internal controls but leave it yet entirely unto directors.
Corporate scandals show beyond doubt the directors' failure in this regard. It calls for strict monitoring that they now do so. Reminding them of their responsibilities would not do; auditors should be required to report on them, as elsewhere.
Reviewing and reporting on internal controls would doubtless increase audit fee. But audit fee is so tiny a fraction of cost that the increase shall not affect either the dividend payout or the P/E ratio or reduce the performance to "red." Even if were to so affect, the increase is justified on cost-benefit basis.
AUDITORS AND REGULATORS: Pinning of expectations on 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 plenty of times [the 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. (Change your auditor; expect a call from the PCAOB, Stephen Taub, CFO, 24 September 2003).
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. (SEC Questions Auditor Turnover, Criag Schneider, CFO, 23 August 2004.)
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 (Section 234 ZA).