The Hindu Business Line : When weaknesses show in controls internal

THE Public Company Accounting Oversight Board (PCAOB), the American regulator's response to the Enron/Worldcom financial fiascos, has been busy registering accounting firms, issuing auditing standards and conducting quality checks on the work done by accounting firms.

The standard that has kept accounting firms and companies worldwide busy is Auditing Standard No 2 — An audit of Internal Control over Financial Reporting. In a nutshell, this standard asks companies to do a thorough review of their internal control systems and asks the auditor to perform a validation check later in the form of a report.

Have weakness, will disclose

The PCAOB is now contemplating an innovation — giving the auditors the right to more quickly assure investors that companies have plugged the loopholes in their systems and thereby assure accurate financial reporting.

It is considering permitting auditors to give "snap verdicts" on the remedial action taken by companies to correct defective internal control weaknesses. Stanford Law School and Cornerstone Research conducted the inevitable survey which discovered that companies suffered smaller falls in their stock prices if they disclosed details of the weakness in their internal controls. The companies that admitted to gaps (141 of them) in their internal controls suffered average falls of 1.5 per cent compared to their more silent brethren who ended with average falls of 3 per cent. While this would seem to be a drama of percentages, the research concluded that there were better chances of an improvement in the stock prices if the weaknesses are disclosed and fixed.

However, credit-rating agencies do not take too kindly to continuing or pervasive internal control problems and do not waste much time in downgrading such companies. Even from the auditor's point of view, it was felt that the chances of getting a positive report were better if a disclosure was made of the weaknesses in the internal controls and remedial measures taken to nip them in the bud. The PCAOB is mulling over permitting the auditors to give a public statement about the result of their review promptly rather than wait for time-lines mandated by the Sarbanes Oxley Act (SOX).

Whistle-blowing

Although the measure may sound radical, it could be worthwhile permitting auditors to "whistle-blow" glaring weaknesses in a company's control systems to prevent collateral damage. The quarterly reporting norms devised by the Securities and Exchange Board of India (SEBI) ask auditors to comment on the present status of qualifications made in their report for the immediate previous financial year. While this is a good measure to determine if the accounting violations persist, one assumes that fresh qualifications would have to be made in the review report for that particular quarter.

While companies report that the results have been "reviewed" by the auditors, it takes some effort to get the review report of the auditors. There can be no doubt that auditors — who nowadays are a part of the Audit Committee of any organisation and are privy to a plethora of information — are best suited to discover and report persistent and deep accounting irregularities. If they are armed with "whistle-blowing" powers, it could warm the hearts of many an investor.

(The author is a Hyderabad-based chartered accountant.)

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