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A rear-view drive

R. Srinivasan

FOR all the sophistication and advances that the US has made in every field of science and technology, an archaic accounting practice is increasingly triggering off corporate bankruptcies and lawsuits in that country. The practice relates to the restatement of audited statements of accounts of previous years as also the issuance of proforma quarterly results some weeks ahead of the official results.

Cases of restatement of audited statements of accounts of several prior years are now occurring with such monotonous regularity that investors and analysts almost take these in their stride. Indeed, the problems Enron Corporation is beset with are due, in part, to the company seeking to restate its audited accounts for prior years. The main reason companies in the US resort to this practice stems from the fact that, unlike in India, audited accounts are not mandatorily approved and adopted by shareholders at annual general meetings but are only commented upon by the audit committee in the annual reports as part of management discussion and analysis. Companies are, however, required to file with the Securities and Exchange Commission (SEC) an annual report for each fiscal year in Form 10-K and need only to file the restated accounts if and when a restatement takes place. In almost all cases, restatement of accounts arises as a result of improper revenue recognition for deferred sales and improper accruals for expenses and bad debts reserves.

While Enron restated its accounts back to 1997 resulting in a reduction in reported profit by more than $500 million, Xerox Corporation restated its results earlier this year for 1998, 1999 and 2000 acknowledging that it had misapplied a range of accounting practices. Xerox may still be asked by SEC to further restate its accounts for these years. The SEC reportedly is looking into the companys accounting practices relating to leases, having booked more of the lease receipts as income upfront than spreading part of it over the life of the leases, especially as the lease billings included charges for services to be rendered in the future.

The question naturally arises as to what safeguards are there to protect the interests of investors and other affected persons who depend on these audited statements for their decision-making. There exists a watchdog body called the Public Overesight Board (POB), which is charged with overseeing and reporting on the quality-control aspects of audit procedures to help assure regulators, investors and the public at large that audited financial statements of public companies can be relied upon to provide an accurate picture of their financial health.

It is an autonomous body funded by dues paid by SEC Practising Section of the American Institute of Certified Public Accountants which is itself composed of accounting firms that audit the financial statements of public companies filed with the SEC under Form 10-K. The POB bases its judgments on the peer review reports and by reviewing allegations of audit failure.

As a part of the self-regulatory structure in the accounting profession, major accounting firms hire one anothers service every three years to conduct peer reviews, representing assessments of their accounting and audit practices. This is a measure of ensuring quality control in the auditing procedures adopted by the firms, but its usefulness has recently been called into question by the lawmakers who are inclined to believe that reviewing firms are more likely to whitewash or reconcile problems found in client-companies so as to be able to issue a clean peer-review report.

After all, these big audit firms get fat fees from large corporations such as Enron and could be inclined to pass over flaws in accounting for fear of losing their clients. Enron has disclosed that it paid its auditors, Andersen, $25 million in audit fees annually and an additional $27 million for non-audit services. Nothing could be more embarrassing for a reputed, top audit firm than to be told publicly that the original accounting for some of the transactions in the previously audited statements violated the generally accepted accounting principles as Enron did recently.

The other practice of issuing proforma financial information relates to the exclusion from earnings of costs associated with mergers and acquisitions, non-cash compensation, research and development and amortisation of goodwill. These proforma releases, issued weeks ahead of the declaration of official results, are now resorted to by hundreds of companies and are mainly intended to make companies earnings look better by the exclusion of these expenses. The SEC, a week back, was forced to issue warnings, threatening to sue companies that mislead investors with proforma accounting.

This makes one wonder why companies, in a country having a strong regulatory framework in the profession, are increasingly resorting to these practices. The only reason one could perceive is the intense pressure on company managements from investors to sustain growth and profitability and, also, sustain the companys share prices on the stock market.

Acknowledging the fact that audit effectiveness left a lot to be desired, the POB had constituted a panel for carrying out a thorough investigation of the current audit model and, after a great deal of debates and deliberations, including public hearings and written comments, the panel had submitted its report last year. The panel had observed that the conduct of audits and the governance of the profession clearly needs substantial improvement particularly as the global economy grows more complex and the demand on the capital markets in the US grows more intense.

The report, since approved and released by the POB, makes several recommendations, including the performance of some forensic-type procedures on every audit to enhance the prospects of detecting material financial statement fraud and strengthening the POB for overseeing standard setting (for audit, independence and quality control), monitoring, discipline and special reviews.

Even the chiefs of the big audit firms have been reported to have agreed about the need for abiding by higher standards of auditing in the future stating that backward-looking financial statements delivered on a periodical basis no longer are sufficient to communicate real value and risk.

Viewed in the light of the spate of problems now occurring in the US from restatement of prior year audited statements and proforma accounting, the accounting and auditing profession in India has reasons to pat its own back for the manner in which regulatory provisions are enforced and monitored. The practice in India of audited accounts being approved and adopted by the shareholders at annual general meetings precludes any scope for re-opening or restating the accounts of any year, and errors or omissions in the preparation of the financial statements of one or more prior periods would only be rectified by a prior-year adjustment shown separately in the current year statements.

Further, developments in the US and elsewhere in the quest for achieving audit effectiveness would need to be closely watched so as to plug possible loopholes that could be exploited by managements under pressure for increasing profits.