Opinion

Balance-sheet credibility must be restored

R Anand | Updated on December 19, 2019 Published on December 19, 2019

Information overload Compexity of financial statements is mind-boggling   -  catenarymedia

Multiplicity of regulations and interpretations, amidst the temptation to resort to window-dressing, have caused a muddle

Balance sheets are like statistics. What they reveal is interesting. What they conceal is exciting. Corporate balance sheets have developed and evolved over time, and today the complexity of balance sheets, with the added spice of new accounting standards, is mind-boggling. Annual reports are a maze of information and literature. A cynic remarked: “With the information overload in annual reports, it is virtually impossible to unearth where the profit and loss account and balance sheet are hidden.”

The next question that arises is how credible are corporate balance sheets today, in the backdrop of several corporate scandals and failures? For India to become a $5-trillion economy, it is imperative that financial information and corporate balance sheets are accurate and credible. Global and Indian investors invest in Indian companies on the strength and weight of these numbers. Directors on corporate boards and auditors of companies are mandated to ensure that the numbers stand scrutiny.

Role of the CFO

The chief financial officer (CFO) is the nerve centre for the dissemination of financial information. Historically, the CFO was called the chief accountant, whose main focus was to ensure the annual accounts are properly drawn up and presented. The job was repetitive, unexciting and mundane but essential in the overall corporate eco system.

A bulk of the accounting tasks was manual till the 1980s. The emergence of technological tools like Tally and SAP and the 1991 reforms changed the role of the chief accountant. He was forced into multi-tasking activities like dealing with bankers, rating agencies, regulators, treasury managers, etc. Today, the job description of a CFO is very different. He has become a power centre in his own right.

The downside of this evolution is that the attention to basic and pure accounting has receded. There are questions being raised on whether balance sheets are less credible today because the CFO spends less time on basic accounting and more on other functions. The CFO is the trustee of the finances and related information, relied on by all stakeholders. Ideally, the CFO and MD should act as a maker-checker for each other.

However, in some cases, the top management-CFO nexus has become a matter of concern. Sathyam and CG Power are classic examples, where such a nexus lead to falsification of accounts and misleading of stakeholders. The relationship between the MD and the CFO is crucial for the overall hygiene of annual accounts.

If the CFO plays a muted, second-fiddle role to the MD, then there is reason to worry. If the CFO is independent and focusses steadfastly in producing the right set of information and numbers, it comforts the audit committee and the board. Who is to evaluate and rate the CFO?

Today he is rated by the MD; and herein lies the problem. Even if there is no nexus, by design the CFO might be forced to toe the line of the MD. A radical solution could be the CFO being made to report directly to the audit committee, which in turn as a process of evaluation takes relevant inputs from the MD.

Ideally, the audit committee should also consider which decisions the CFO has taken independently against the diktat of the MD. This will be the real test, bringing out the professional acumen of the CFO.

There have been instances where the CFO has been forced to record transactions as sales, which conform to proper accounting only in form but not in substance; the underlying reason being that the incentives of the MD have a correlation to sales and profits.

When there is a nexus between the MD and the CFO to manufacture a convenient set of numbers, it becomes virtually impossible for the auditor to pick up the meticulously-constructed web of misrepresentations and manipulations. A forensic audit is the solution, but that kicks in after the damage has been done.

De-linking the CFO from appraisal of the MD will obviate practices that act against the interests of the company. The time has come to seriously consider rotation of CFO after, say, a maximum of 10 years.

There is a Central Vigilance Commission (CVC) circular (applicable to Government enterprise)] dated August 23, 2018, the main portion of which states: “…. Analysis of frauds that have taken place in public sector banks as well as other organisations show that one of the reasons for such frauds was non-implementation of the rotational policy. It is once again reiterated that rotational transfers of officers continuing beyond three years may be strictly carried out from the sensitive seats/posts...”

The benefits of institutionalising roles and responsibilities instead of personalising them cannot be overemphasised. The audit committee’s task becomes onerous and it is expected to exercise the required supervision on the quality of the numbers. In the recent past, however, audit committee meetings have been converted into seminars on accounting standards rather than actual audits.

Auditing standards

Accuracy and reliability of the financial statements brings to the fore the efficacy and quality of audit. With all the furore around the failure of audit leading to the crisis of credibility, the fact remains that auditing is now a thankless job. The sheer volume of transactions and the pressure to release quarter-on-quarter numbers is taking a heavy toll on the profession.

It is impossible to verify all transactions and there is a heavy reliance on internal systems and procedures to bring out the correct set of numbers. Technology and stratified sampling methods ensure that transactions and data picked up for scrutiny represent the correctness of the picture as a whole. But still questions remain as to whether these modern techniques ensure that nothing is missed out.

The issue is more complicated, since audit reports convey the language of ‘true and fair’ and not ‘true and correct’, which unfortunately is the expectation of the users of financial statements. In any balance sheet only two items are accurate — share capital and cash balance. The rest are estimates prone to subjectivity.

The introduction of IND AS has distorted the overall presentation and strength of balance sheets. When an accounting standard lends itself to two plausible approaches, the management and auditors generally agree on the one that provides a short-term booster to profits to increase the earnings per share. In other words, playing to the gallery — the stock market — is preferred option to a conservative approach that provides a cushion for any long-term hiccups.

Elimination of various alternatives in the accounting standards has been by and large achieved by the introduction of IND AS, but it has in turn led to various judgment calls and assumptions which decide the final numbers.

A classic example of this is the accounting of a government grant, where treatment as capital as well as revenue is possible. Companies tend to follow an approach based on their own immediate priority and select a method that is more suitable on a short-term basis.

Another case in point is the recent introduction of IND AS 109, which stipulates the expected credit loss and the provision to be made in the accounts for NBFCs. The assumptions built into the calculations are so many that there are several possible answers to the issue, and all are in accordance with the guidelines.

 

The veracity of balance sheet numbers is inextricably linked to the fabric of honesty, sincerity and integrity. If these three pillars stand erect, we do not require any regulations to dictate quality of balance sheets. It is about the crisis of credibility.

The writer is a chartered accountant

Published on December 19, 2019
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