Accounting No Longer The Be-All And End-All For Business, Says Rashesh Shah In A Chat With PR Ramesh, YH Malegam

With accounting standards changing across the world, is there a need to go back to the boardroom and reassess the scope of financial statements? How does one look at accounting to reflect values that cannot be measured while assessing a company?

At a conference—Gatekeepers of Governance—hosted by former Securities and Exchange Board of India Chairman M Damodaran, Rashesh Shah, chief executive officer of Edelweiss Capital, and YH Malegam, former chairman on the National Advisory Committee on Accounting Standards, attempt to answer these questions posed by PR Ramesh, chairman, Deloitte India.

They discuss the relevance of financial statements, who they cater to, and what role they primarily serve.

The discussion highlights:

• The relevance of accounting.
• Quality and relevance of financial reporting.
• Corporate governance and accounting standards.
• Whether integrated reporting should be made mandatory.
• Making financial statements more meaningful to all stakeholders and simpler.

The discussion also highlights the different ways in which financial statements are interpreted, and whether there is a need to revisit accounting rules.

Watch the full discussion here:

Read the edited transcript of the conversation here:

PR Ramesh: What are the opening remarks for this subject?

Rashesh Shah: It is important to know that world has become more complex. So, we need inputs from multi-dimensional framework. Accounting is only one of them. So, this accounting is be all and end all to see the health of a company or to access where the company is not going to be adequate. We need credit rating agencies. We need various other forms of people accessing the health and quality of a business.

The human mind is such that it will stick out and it will attach lot of weightage to outliers. I started my career 30 years ago when I was working in ICICI and even then, a copy of annual report was a great achievement. I still read annual reports. In last 30 years, the quality of annual reports has improved a lot. In spite of changes of intangible, good will, IFRS and Ind AS which we have gone through. The kind of disclosures, the accounting standards, all of it what it was then to now has improved. It is not adequate. There is lot more to be done. Our expectation that accounting should give us lot more answers is always going to be there. We have come much closer. The recent introduction of India is great one. It has improved the overall quality. There are tradeoffs which we have to make. We live in world where it is hard to access fact. The messenger is important as the message. Your credibility is important as you are saying. Everything is going to be colored with some opinion or the other.

One of the first class in accounting in MBA class where we had case study on sales. We had a three-hour discussion on when does the sale actually happened. When you got the order and the advance, when you complete manufacturing, dispatch the goods, when the buyer accepted the invoice, when you got the proceeds from the buyer, when the sale happened, when did you take it into books as sales. I thought how we can have three-hour study on subject like this. At the end of it, you realize everything will be about judgement or call you are making. That this is the point that the sale has happened. Accounting will be filled with it. So, is it loss, profit, Indian gap or US gap? This is inevitable. But is there anything better available to us is the question. I will rather have accounting which we have rather than saying this is not adequate. It is not the thing which you will be blindly depend upon, but it has improved over the years. There is lot more to be done as the world is changing.

Everything which we do whether it is corporate governance or accounting standards, company laws, there are phases of incremental improvement. Then you come to a point where the incremental improvement is no longer a way to go. You need transformation. There is small anecdote about King which highlights this. Kings was appointed as assistant treasury in British treasury in 1918 after the first WWI. That time the mandate given was bring the financial system back to improved version of 2014. They wanted to go back to old ways but in an improved format. The gold standard continued. Kings once again came back to British treasury in 1945 after WW II. But the mandate which was given at that time was not to improve the old version but transform the whole thing. That is where we get better goods and new global economy order. He said that here I am again in British treasury and have completely different mandate. There are times you need transformation and incremental improvement. All of us feel that we are getting into stage in accounting that we need some transformational approaches to this. Incremental approaches will not allow us to cope up with complexity, new economy and new way the new world is expecting accounting to showcase.

YH Malegam: We should first recognize that the whole essence of corporate governance is accountability of the board of shareholders. Therefore, you need an instrument by which you provide that account and financial statements are one of the methods for which the accountability is provided. We have to ask question to ourselves is whether the financial statements in their present form do provide adequate account. Accounting has been in existence for a very long time and few changes have taken place. The important difference which have taken place is, till recently it was believed that whole function of accounting wants to provide information for only one group of stakeholders which was the shareholders. There are judicial pronouncements which said that preparedness of financial statements and those who audited them had not obligation to other parties. They could use the accounts and financial statements, but they did their own risk. The auditors which prepare it was not accountable. In recent years, we have found that there are large number of stakeholders who have important stake in financial space. We have bankers, rating agencies, regulators. Perhaps, shareholders are using fewer financial statements than the other agency which are used. These financial statements are inadequate for this purpose of agencies as they were not created to provide information which these agencies need.

Line with that is other development. Because of developments in information technology, growth of financial analyst, we are finding that shareholders no longer getting information from financial statements. Analyst are asking information on real time basis and asking for information which financial statements do not provide. So, far financial statements are concerned, analyst don’t need them, and shareholders don’t read them. It is ironic that on one hand you have lot of effort going in accounting standards, greater sophistication and so on, on the other hand the relevance of financial statements themselves is being questioned. That is second issue you have to look at.

Even for shareholders, why is financial statements proving to be inadequate? Because their concerns are now different. They are not concerned with past but with future. They want to know the risk which the company is exposed and how is it that those risk are addressed. They want to know the opportunity available to company and the specific strategies of management by which those opportunities are taken benefit of. Therefore, they are more concern with future and what is happening with company. They are also concerned with how the company is being managed, whether there is efficiency, absence of fraud. Financial statements by themselves will not provide this information.

Therefore, the moment has started which is known as integrated report. It addresses all these issues. It takes the financial and non-financial information and it uses that combination to report to shareholders on all these concerns which shareholder have. The time has come where we need to encourage more and more companies to publish the integrated report. Some are already doing so. Or even for mandate integrated report should be required.

There is also question of fraud. This s big elephant in room which no one wants to see. If there is fraud and financial statements are vitiated, then everyone who relies on it and banks, rating agencies, etc will draw wrong conclusions and which will create serious consequence for economy. We have not asked the question of who is responsible for detention of frauds. Auditing profession says that is not our job. If we come across the job, we will report it, but we are not searching. If you ask audit committee, they will say we are not competent to detect it.

If you analyze it, there are two element of frauds which we have to recognize. There is management fraud. Fraud which encourages the vitiation of financial statements to provide incorrect information. Or fraud may be of type like taking away money which is different issue. So far the first element is concern,

there is responsibility where the players in corporate governance have to accept. Anecdotal evidence suggest that this sort of fraud takes place in some areas which can be detected. It takes place in related party transactions, through diversion of funds, through the creation of shell companies, mostly companies which are abroad. It takes place through a multiplicity of subsidiary and associates. All of this gets reflected in financial statements.

In two major frauds, what has happened is relevant. There is one fraud where the bank has lent through debentures, several hundred crores of rupees. That money was lent to company and company lend it out to subsidiaries. But in books of accounts of company, neither the borrowing nor the loan to subsidiary is accounted. Therefore, this company continued to show large amount of cash available with it. Based on that this rating agencies continue to show this companies as a triple A rated company. Based on that banks continue to lend money to the companies. If these accounts are being correctly reflected, none of this would have happened.

There is another situation where a company borrowed money from a bank and on the security of asset, it purchases the asset for several hundred crores and later on it was found that the asset was purchased by the one who sold it to the company for a few lakhs of rupees. So, cost of asset is reflected in books of account. That provides the security on the basis which banks are lending. There are innumerable such cases.

Financial statements lose their relevance, if those in responsible for preparation of financial statements for the auditing of financial statements and management of corporate governance within the organization don’t exercise great proportion.

It is one thing to say that financial statements are inadequate. It is true, but we cannot do away without them. In different context, Winston Churchill said that democracy is not the best form of government, but we are nothing better. So, we may take the same exercise. It is important to recognize that in an attempt to make financial statements more meaningful, there have been type of over kill. Academic exuberance has resulted in financial statements becoming more technically correct. It is also resulted in financial statements coming more and more incomprehensible to the layman. This is the problem which have to be addressed. That we should not go back to a situation where financial statements in simple form give simpler features which is necessary for reader. Instead of all of this we are getting mired in a large volume of notes, in large number of technical sophistication which are sometimes not material. It is the move which we need to look at.

PR Ramesh: Do you think the integrated report should be mandated across? As a user what will you like to have in financial report to be more meaningful?

Rashesh Shah: A company is as complex as human body. When you get the pathology reports, you get the understanding of how healthy the body is or are there any underlying issues. You might have great ECG and a stress test done and we have seen stories that people collapsing in marathon. It is hard to convert the complexity in reportable parameter. The same thing which applies to human body applies to organization, accounting and financing. It is great analogy that no matter what we do we will get to approximate understanding of what is inside.

On integrated reporting, it is not only essential, but it is inevitable. We should apply it to top 500 companies. Accounting is not the only way to understand the health of the company. There are lots of other things like corporate governance, succession planning, future risk, technology adaptation. So, the companies which have higher stakes, we have to raise the bar. To raise the bar, the cost benefit is debated. On a personal level, I think it is for a good cause. We will again not get it in perfect way. it will be better on many senses of parameters which are required. The end game is to understand what is going on in a company. Third party investors, stakeholders, creditors, borrowers, even employees will get an understanding of what is going on in a company.

It is not only important to understand what blood pressure is but along with sugar report, can I get a quick and dirty understanding of how healthy you are. If you read the book Blink by Malcolm Gladwell, he has a story that in an emergency room, they used three quick parameters to access the risk of heart attack. So, instead of going through long, elaborate test when somebody came in and they did only three things to quickly access what is the probability that this individual will get a heart attack. But it was required for emergency route. We need a multi-layer approach so there is simplicity at one end and complexity at another end. Depending on who the user is what is use for that user you can go with this or more complex report. It is same with health analogy. Sometimes you have to say that your pulse is okay, blood pressure is okay, and you are okay. If you family history has smoking, then you have more test. We need gradual multi-layer approach. You have to look at cost and benefit. The larger company should adopt cost and they have to accept cost of having complex analysis. The smaller companies can get with simpler analysis. If something goes wrong with it, then the stakes are smaller. Anybody worked in organization realize that we have data, analyses, we convert into MIs and opinions. Same thing also applies to accounting. There will be data but there will be analysis and opinions. As long as we know what is what it is easier to know how to use it accordingly.

PR Ramesh: Do you believe that we don’t have enough signals in financial reporting to alert people? Do you think there is interpretation of what the product is produced? Are you accountable on hindsight or foresight?

YH Malegam: There is difference between financial statements, information which is given in the statements and the interpretation of that information. If the information is available and someone doesn’t interpret correctly then I don’t think you can blame the financial statements. It happens very often.

There is a very simple solution. The problem is every accounting standard has free element. It has element for recognition, for measurement and an element for disclosure. When you look at standard for itself, you feel this disclosure is necessary because this will help the person. It is when you aggregate the disclosure of all the standards, you realize that there is too much of disclosure and therefore the essential get hidden.

In every standard, there is a test that you shall disclose only that which is material. When you look at an item and see what the disclosure is required in that item and you disclose what is material. But the standard doesn’t say you make disclosure only when the item is material. To give illustration, you have standard on leases. You will see that you have two pages of information on elites. And that information is given irrespective of whether you have leased all your equipment, or you have leased a couple of motor cars. So, the answer is standard of materiality should be applied to item itself. If the item is not material, don’t make any disclosure.

PR Ramesh: You have new leasing standard which will come from 1st April. It does away with concept of operate leasing and try to bring everything on balance sheet. So, what will be its result?

YH Malegam: If as a result of accounting standard coming in, the accounting practice changes and therefore it has an impact on those who are regulating business. The answer is you cannot stop a change in accounting practice if you believe that the practice is more appropriate one. When you make a change, you make a disclosure, so that those who look at statements as change apply the test that whether the change in effect has resulted in fundamental change in business itself. That is matter of interpretation.

Every regulator wants to protect its stuff but that doesn’t mean that you do not make changes. It means that we have to sit together and work on a practical way of dealing with these issues.

Rashesh Shah: Every change comes at a cost. Hence there is argument that allow the status quo to continue or to change. Even if change comes with improvement it is still comes at cost. That is why time to time we have to evolve. The world is getting complex, newer things are coming. Whether it is leasing example or any other, I would say change is required all the time and even if it comes at cost, we try to minimize the cost and not avoid the change. It will disrupt. The world is becoming complex at different pace than we will be able to handle it. increasingly, the risks are moving from on balance sheets to off balance sheets. So, how can we capture it when accessing the health and well being of an organization. We will have to constantly keep on changing. The new IFRS guidelines which we have adapted was a long over due change required in India. It is about when you are accessing third party capital, whether it is bank loans, on holders or equity shareholders. More corporates access equity from third party investors. There is entire agency manager conflict which comes in. You will need things like accounting, credit, analyst, all of it to constantly access what is going on. You will never achieve that perfection. You have to keep on trying. Every change, if it is for better, it comes at a cost, but it is for the good.

No matter what we do with accounting standards there is something like wisdom of crowds that can be harnessed. The equity markets reflect the underlying reality a lot earlier than actual accounting. We have cases like Satyam which was a shock but when the company’s health is deteriorating, if there is equity market proxy for the company, there are enough early warning signals. As we use annual reports and accounting statements and use all of this and bring some synthesis on it and make it for user. It should be a reflexive relationship because if everything looks perfect, but the stock price is telling you something else, it is worth investigating a little bit more. Each one will impact the other.