Qualified Audit = Restatement?
SEBI has taken a hard new stance against 'qualified' audit reports. Substantial or material qualifications may lead to a mandatory re-statement of accounts and could even be accompanied by penalties & punishment. I did some digging around and here's how I'm told this new scrutiny process will work. All audit qualifications will have be mentioned in a form that will accompany annual audit reports filed by listed entities with the exchanges. The exchanges, based on a prima facie scrutiny, will report significant qualifications to SEBI's QARC or Qualified Audit Report Review Committee.
The QARC will refer the qualification to ICAI's Financial Reporting Review Board for an opinion on whether the qualifications are justified or not. This opinion will then be considered by SEBI's Corporation Finance Department. If the FRRB says the qualifications are justified i.e.; the auditor is right and the company is wrong, then SEBI may mandate the company to restate accounts.
Depending on the severity of the situation, SEBI may even consider penalties & punishment. It's a brave new step to protect investors from the increasing number of qualified accounts and to talk about it I am joined by Nawshir Mirza- well known Independent Director, Jamil Khatri of KPMG and Amarjit Chopra, Former ICAI President.
Doshi: You sit on the boards of several companies, head audit committees, you have to deal with auditors and qualifications and I don’t mean deal with in a negative sense- it is a brave new step that SEBI is taking and you can’t complain about the step itself. But what will be the implications of this be? How will it work? What is your assessment?
Mirza: Two immediate responses to that. First, I think it is an excellent step and I am on for it because 60 years I have never seen any regulator whether it is the registrar of companies or SEBI or the stock exchanges or whoever else do anything about qualified audit opinions, it is almost become a joke. So that is my first response.
The second one, from the process you just described my only concern is that the processing use to be so bureaucratic and protracted that by the time SEBI finally reaches a conclusion to direct the restatement several quarters or annual closing may have been passed and companies would have continued to issue a financial statements that perhaps repeat the same deficiency which at that point of time under scrutiny. How can we short cut this whole process to stop these four or five stages for SEBI to reach a conclusion. I think the FRRB is doing the main job and finally SEBI has to take action.
Doshi: You are suggesting something like the exchanges refer the qualifications directly to the FRRB?
Mirza: I think so. The QARC can be cut out and the other thing is do companies because there must be due process – companies should be able to represent their point of view because the auditors may have a point of view that does not mean that the companies are wrong.
Doshi: I would still imagine that representation is probably made at the FRRB level?
Mirza: I don't know.
Doshi: That has not been laid out as yet. So those are fair points. Your thoughts on what this will mean for companies and for investors?
Khatri: I think this is a very positive kind of step. One of the things as an auditor, as an accountant I always use to feel is that all the effort that you put in to the audit is that really reflected in the final results which go out to the investors, I will give you an example – there are many cases where there are five-six qualifications but when you look at the media, when you look at what is reported by the company and now investors look at the financial statement they still look at the EPS as one number without looking at the numerous qualification behind that. I think if we have a mechanism whereby the numbers which are reported are after adjusting for the qualification which is what happens in an IPO situation already because SEBI requires that to be restated qualification and other matters I think it cuts the chase and presents the right numbers.
I just want to add one more thing that this shies away from the final step which in my mind would have been a very-very kind of ultimate step in terms of making this work which is a qualified audit opinion not being accepted by the exchanges at all. As you know this is what happens in many advance markets including the US, where a qualified audit report is not accepted in filings by the security and exchange commission. I think we have made a big leap. We have done something in the right direction. We have stopped shy of the kind of the ultimate objective in my mind and then I again echo what Nawshir said that the effectiveness of this process is going to depend upon whether this becomes six months to one year affair or we do it in a timely basis such that the relevance of this process is maintained as far as the investors are concerned.
Doshi: I am going to get to the no qualifications aspect in just a bit but before that Mr. Chopra everybody on this panel and I am including you in that applaud- this move by SEBI but the concerns are on the process front. What do you make of the role of the FRRB in this is the point I want to bring you in on because the FRRB is going to have to make the opinion on whether a qualification is justified or not and hence whether a restatement is required or not? Is the FRRB equipped today to do this?
Chopra: So far as the equipping of the FRRB is concerned, let me say very clearly that FRRB is fully equipped but let me take you to another angel very frankly and that’s what I want the two other panelists to really look at it.
When in 2002 the FRRB was brought into existence, the purpose was not to look at the qualified reports, to be very honest. The purpose was that if at all some of the financial statements do not comply with the accounting standards, do not comply with the regulatory requirements then what kind of audit reports have been issued in respect thereof. Suppose the auditor has defaulted in something then probably the case could be referred to a disciplinary committee because we don’t have powers to go against the company.
Doshi: Are you implying that the scope of the FRRB will have to be widened and the FRRB will have to come back with opinions fairly quickly for the time process to not sort of run into several months?
Chopra: To some extent I fully agree with you. The FRRBs term of reference will have to undergo a change and probably the process will have to be improved upon that we can really come back to SEBI immediately after the SEBI refers the cases to us.
Khatri: We will have to relook at the composition of the FRRB, we will have to relook at the staffing, for example today the FRRB relies a lot on volunteers, people who volunteer to play this role for the review role, etc. If this going to be such an important function going forward then we will have to, the regulators will have to look at the FRRB, look at the staffing both at the overall board level as well as in terms of people who participate in these reviews of this qualification to see whether that’s sufficient or not.
Mirza: I also had a question and maybe Mr. Chopra couldn’t hear it that time. When will the company have an opportunity to represent its view? Would it be in the FRRB or would it be at SEBIs level or where would it be? Do you have any idea on that?
Doshi: Mr. Chopra?
Chopra: Very frankly not sure. I have gone through this and I don’t find an answer to that. Very frankly in FRRB we have been writing to the companies, companies have been rather saying that we are not answerable to you because we can only proceed against our own fraternity. Now once the SEBI stepping in to this entire scene, I think as I can read it, it does not say that an opportunity will be given, it only says if the clarification is given and that’s why one of the issues that I am posing before you as an independent director should it mean that whatever directors have actually responded to in the directors report to the auditors qualification should be considered to be their clarification or should it be that a fresh opportunity has to be given to the management to say as to what do they want to say because I don’t think they can really contradict their view, whatever response they have already given.
Doshi: That's a fair point.
Mirza: Excellent point. I think you are absolutely correct about that. The first is till today because nothing happened, many times managements didn’t even bother to respond in the directors reports to qualification or if they did it was a cursory kind of response that it speaks for itself or some such thing. But the fact of the matter also is take a case where is an entity controlled or not controlled and therefore should it be consolidated or not? It’s an abstruse accounting argument discussion, it’s not something which either the auditor in his report can elaborate upon nor for the board, their report is intended for the lay shareholder to set out a complex argument as to why this particular entity is not controlled and so we didn’t consolidate it or vice-versa. After all in Enron one of the fundamental issues was of whether there was an entity controlled or not controlled. So I don’t think that the mechanism of the response in the director’s report is a sufficient mechanism for the company to be able to make its case and I think the FRRB would have to therefore operators are tribunal to listen to both sides and then reach a conclusion.
Doshi: That would have to be the case because if it is not done at the FRRB level the FRRBs opinion on whether they should be a restatement or not will be pointless if SEBI has to then rehear the case, bring in according to principle of natural justice, allow the company to make a presentation then arrive at a decision of its own then it becomes even longer drawn.
Mirza: An appeal to the tribunal, to the courts you could have several years.
Chopra: It could mean that FRRBs will have to be given the statutory powers by the government otherwise the companies will keep on saying that we are not answerable to you. That is the fundamental point if you really ask me. If we don’t have that power then I think it is only the SEBI which will have to do that hearing then FRRB will not be able to do that.
Doshi: SEBI has to do the hearing; the FRRBs opinion then becomes almost redundant because you are hearing afresh.
Khatri: I think SEBI could become the routing agency on this. Even if the questions are raised by the FRRBs to the company maybe that is the opportunity, the questions go from SEBI whether it goes through QARC or any other part of SEBI
Doshi: That becomes even more bureaucratic because the questions go via SEBI, the answers come to SEBI, then FRRB looks at them, then there is follow up questions, then it comes back this could take several years for any decision to be made on a restatement or not then the whole purpose of this exercise is lost. Time is of essence in this
Khatri: I am not disputing that. I am saying rather than waiting for FRRB to be given authority which may require something I think we are all saying the same thing, that effectively there has to be a mechanism whether by giving direct authority to FRRB or creating a routing mechanism through SEBI to give the company the opportunity to respond to the qualification in a manner which is more detailed than what is already there in the directors report and that then becomes the basis for the FRRB to take a final decision. I think the way this is going to be operational will be important which is the same thing that we talked about.
Doshi: And let's hope that listening to this and otherwise as well the regulators will find the mechanics to fix this because I want to move onto the next question and that is what happens to companies with several serious qualifications. I am going to use a company simply as an illustration, Kingfisher. In the recent past amongst the most talked about nine material qualifications, one even raising doubts regarding the going concerns status of the coming. Now in such a case hypothetically speaking if those qualifications are found to be justified by the FRRB and SEBI and a restatement is ordered the very viability of a company or its existence may come into question then how will this work?
Khatri: I will give you another example, not Kingfisher but I dealt with a case for a very large telecom company which had four pages of qualification. They had 34 audit qualifications, a very large telecom company and this company was also listed in the overseas exchanges. As I mentioned during the conversation earlier the overseas exchanges did not permit a qualified audit report to be filed so this company used to over the next six months which were the time period it had to file with the overseas authorities, adjust these qualifications and the numbers which came out were absolutely different. --- (interrupted)
Doshi: So you had a different set of numbers being reported overseas and different set of numbers being reported here?
Khatri: And we are not talking about 10-15% we are talking about a profit turning into a loss and those kind of situations. So I think that’s exactly what is going to happen now that if we are able to enforce this mechanism in a serious manner either the investor will have the benefit of getting that information within the short period of time or as you mentioned overtime management will realize that they cant get away without making these adjustments and therefore these adjustments will start reflecting in the financial statements much earlier then what we have seen in the past.
Doshi: And investors will get a truer picture of the financials of that company. The other outcome potentially of this is that companies apply undue pressure on their auditors and insist that there be no qualifications and I use the word insist in an almost jocular fashion that there be no qualifications because they don’t want to have to deal with the threat of a potential restatement. What is this going to mean for the company auditor relationship here onwards?
Chopra: I personally feel, I am not caring for that kind of a relationship to be very honest but your point is well taken that under the circumstances probably it would happen that the companies would say that if you qualify there could be a restatement but I can only say that the qualifications are so severe I don’t think any auditor can promise on that. If the kind of qualifications we are talking of, I think no auditor will be able to really take a chance. I think we have to be on the watch and I am sure irrespective of anything this is probably one of the most applaudable steps that any regulator has taken and we must go ahead with that and we must try to implement it
Mirza: You are absolutely right that companies, which are running into rough whether may, I don’t say all of them, but some may search for pliable auditors who are perhaps more susceptible to pressure well in advance of actually running into rough seas so that’s one think, but on the other hand I think it certainly strengthens the hand of the auditor and I think many auditors will take advantage of this further strengthening to say that we now really are serving a purpose because till now we didn’t seem to be serving our purpose, we qualified, it was a complete waste of time because nothing happened after that because now something is going to happen so that would be a positive thing and I think your first leading question was essentially what Jamil was saying wherein many jurisdictions they don’t accept qualified audit, but I don’t think we have reached the state of maturity in the quality of our accounting as well as in the quality of many of our auditors to be able to say that because you could well find that very justified things are being qualified or things where is a reasonably good argument on the company’s side the auditor nevertheless is qualifying and then to force the company to restate may not be an entirely fair thing. (interrupted…).
Chopra: I think if at all those cases are there this could be absolutely negligible to my mind because no management allows you to qualify without a reason and I am very clear on that and another thing that I will like to say I am raising an issue rather for Nawshir and Jamil- so far we are concentrating only on the qualification under section 227(3). What happens if there are qualifications under section 227(4A) also. If the auditor says that the funds have been diverted if he says that the company has defaulted on the stretch, we have not even looked at that particular action what SEBI is going to do, SEBI is only saying that restate the accounts.
Doshi: I have an answer to that. I have been given to understand that depending on the severity of the situation and depending on what kind of qualification therefore it is SEBI may even choose to accompany the restatement order with penalties of some sort or punishment as well against the management not just in the case of qualified audit report, the market regulator will also scrutinize audit reports where accounting irregularities have been pointing out by the Financial Reporting Review Board (FRRB), again details on that process is still awaited, but it’s a good start.