No longer easy to cook up the books

If auditors disagree with the results, the financial impact of their observations will have to be plainly spelt out

As a regulator of listed companies, the Securities and Exchange Board of India recently issued a plethora of amendments to different regulations. One of the significant amendments relates to filing of a statement on impact of audit qualifications in a tabular format with stock exchanges.

Unlike certain developed jurisdictions such as the the US, where companies are not allowed to file financial statements with audit qualifications, Indian stock exchanges (or SEBI or other regulators) continue to accept financial statements with a qualified auditors’ report.

In the US, if financial statements do not conform to the generally accepted accounting principles or GAAP, they are presumed to be inaccurate or misleading, irrespective of any explanatory disclosures.

Matter of difference

Audit qualification is generally a matter of disagreement between the auditor and the management. A modified/qualified audit report indicates that the financial statements/results are materially misstated. The impact of qualification/s may be quantifiable or may not be determinable.

Still, the qualifications may indicate that financial results presented by the management do not reflect the true and fair affairs of the financial transactions of the company and may accordingly have a significant impact on stakeholders’/investors’ decision making.

An audit provides users of financial statements reasonable assurance that the statements are in conformity with GAAP and relevant regulations. The contribution of the independent auditor is to give credibility to financial statements, which are relied upon by creditors, bankers, stakeholders, the government and other interested third parties.

Ideally, qualifications should be avoided as they bring a negative perception for companies. This can be possible only if the issues are resolved between the management and the auditor. Further, for qualifications that are not quantifiable (e.g. lack of sufficient appropriate audit evidence/scope limitation), the auditor is permitted to state the fact through a limitation of scope or disclaimer of opinion.

While qualification is a common practice in case of a disagreement, SEBI provided for a mechanism to address qualified audit reports. Till November 2015, listed entities were required to submit a form (Form B) for a qualified audit report together with annual report.

The qualified opinion was reviewed by a SEBI committee and the Institute of Chartered Accountants of India (ICAI), and based on their recommendations, SEBI could ask the companies to either get the opinion rectified or revise the financial information to address the qualifications.

The revised financial information was submitted as pro-forma results (revision to the results already filed/ submitted) and companies would further adjust their next year financial statements for a prior period error.

Further, it should be noted that Form B was required to be submitted along with the annual report which are filed must later than the financial results (filed within 60 days of the year-end). Also, no information about the qualifications was required to be filed for the quarterly results.

There’s more

While this process provided a meaningful mechanism to address the disagreement between the auditors and management, it failed to provide timely information to stakeholders.

Essentially, a financial result published by a company could be misstated by a significant amount and not known to the investors at the time investment decisions are being taken. Also, Form B provided for limited information — i.e. qualifications with management explanations and not matters such as quantification and the impact on the financial results.

In September 2015 and May 2016, SEBI amended listing regulations which now require a ‘statement of cumulative impact of audit qualifications’ to be filed instead of Form B. Further, the statement needs to be submitted along with the annual financial results.

It seems that statement may be required for quarterly results as well. The statement contains detailed information such as net worth, net profit, turnover, total expenditure, earnings per share, total assets and total liabilities in a tabular form.

The numbers need to be disclosed on the basis of audited financial results/statements and also after adjusting the related qualifications. Thus, instead of simple qualification information, SEBI requires filing of adjusted numbers.

Further, auditor needs to continue to report for each audit qualification separately, as far as the details, type and frequency of qualification is concerned.

The revision by SEBI is a welcome change and addresses most of the deficiencies noted in previous requirements. The new requirements could be challenging but nevertheless provide the much needed information at the right time.

Also, it seems the SEBI review mechanism of the qualified reports has been done away with. The review needs to be undertaken by stock exchanges now.

It is currently not clear on how the review will be performed but it is interesting to note that in June 2016, sections related to re-opening of accounts and revision to financial statements under the Companies Act 2013, have been made effective. These sections became effective along with the constitution of National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT).

These sections provide for the revision/ restatement for financial statements after approval from NCLT/ NCLAT. Additionally, unlike the existing Indian GAAP, the newly adopted IFRS converged standards (Ind AS) require restatement of previously issued financial statements, in case an error is noted for past periods. Reading all the requirements together, it seems India Inc. is entering the world of restatement (a common phenomenon in the western countries).

Necessary changes

Accordingly now, SEBI/ stock exchanges can apply to the Tribunal for restatement of financial statements of a company, if they believe that the accounts were prepared in a fraudulent manner, on the basis of qualifications filed along with financial results. This could be a significant change from the current practice of recording past period errors in the current year financial statements as a prior period item.

It should be noted that restatements have generally been viewed negatively as they reflect inaccurate financial reporting in the past. Most of the restatements have accompanied consequential adverse impact on the stock prices.

Overall, the amendments bring in some very necessary changes to improve financial reporting by corporate India and providing the relevant information on a timely basis.

As the changes have been introduced within a short-span of time, implementation of the same continues to be a challenge. It is imperative that corporates’ internal processes and systems are robust enough to address the changing requirements.