Changing horizons of accountancy profession

Excerpts from the Brahamayya Memorial Lecture delivered by Mr. Yezdi H. Malegam, former President, Institute of Chartered Accountants of India, recently in Chennai.

CITING THE examples of the Egyptian, Mayan and Syriac civilisations, Prof. Toynbee has advanced the hypothesis that civilisations evolve when people faced by a challenge of gigantic proportions are compelled to make a superhuman effort, that the more hostile the environment, the greater the effort and therefore the greater the quality of the civilisation and that civilisations continue to flourish only when this effort is sustained and decline and disappear where the effort is diminished.

These are lessons we need to remember as we enter into the 21 Century. The changes in the economic and social environment and particularly the spectacular advances in technology are posing similar gigantic challenges to the accountancy profession. We need to identify these challenges and devise the responses needed to convert them into opportunities that can give birth to a new and stronger profession

Four challengesWe can group the challenges into four broad groups, namely, (a) the challenge of utility (b) the challenge of technology (c) the challenge of identity and (d) the challenge of image.

To understand the challenge of utility, we need to understand the fundamental basis for the existence of the profession. Perhaps the most lucid exposition of this fundamental basis was given by Prof. Theodore Limperg of the University of Amsterdam who published in 1932 and 1933 a series of essays which became known as the 'Theory of Inspired Confidence". Prof. Limperg argued that the auditor derives his general function in society from the need for an expert and independent examination and the need for an expert and independent opinion based on that examination. The function is rooted in the confidence that society places on the effectiveness of the audit and in the opinion of the accountant. This confidence is therefore a condition for the existence of that function; if the confidence is betrayed, the function, too, is destroyed, since it becomes useless.

The auditor responds by adapting his audit techniques to meet these changed needs but since this takes time there is a period of time when these needs remain unfulfilled. He called this period, the ``period of uncertainty". We call it the `'expectancy gap". The process of under we may call the ``performance gap''.

The 'expectancy gap" is therefore not a new phenomenon. What makes it different is that the magnitude of the gap and its nature are indicative of a fundamental difference in kind, not merely of degree. First, we are in the midst of a global information revolution whose impact could be as momentous as of the agricultural revolution or the industrial revolution and which I would like those revolutions change the very structure of our professional society. Second, there is the speed of change. In the world of the Internet, a year is eternity. Not only do we need to adapt, we need to adapt fast if we wish to satisfy the demands of the financial markets, our clients and society generally. Third, what is being challenged is not merely the role of the accountant but the very basis on which financial information is prepared and communicated.

The first challenge is to earnings as a single measure of financial performance. There is a feeling that over-emphasis on earnings has distorted the way in which companies are valued and that short-term considerations, corporate gossip and misplaced expectations are replacing relevant information which should be the basis for evaluating the long-term performance of the company.

Enlightened management is therefore making disclosures of information which focuses on the long-term value of the company. These cover such non-financial measures such as product development pipelines, brand awareness statistics, customer satisfaction indices, employee turnover and environmental pollution records. There is also a move to segregate earnings into components of financial performance each of which may have different implications for the sustainability of current financial performance. Non-financial reporting is gradually acquiring an importance wherein it is becoming an important part of the reporting of corporate performance and may even acquire an ascendancy over financial reporting.

A second challenge is to the historical cost accounting convention. It is claimed that a balance sheet prepared on that basis is inherently imperfect in that it does not capture the unrealised gains based on future-oriented market values and therefore fails to disclose the true value of the company. Already there is a move that all financial instruments should be recorded at their fair value.

A third challenge which is allied to the second challenge is the fact that the audited financial statements do not measure the very assets on which today's companies are often valued. As a result, investors have little guidance in making investment decisions, leaving them at greater risk. In particular, they want to know about the value of a company's intangibles such as the value of its brand equity or of its human capital. A research study by Arthur Anderson of 10,000 public companies has shown that in 1998, less than 30 per cent of the market capitalisation of those companies was represented by the book value of assets whereas 20 years earlier, book value of assets represented over 95 per cent of market capitalisation. Therefore, at present, over 70 per cent of market capitalisation of companies represents the value of intangible assets which are outside of the measurement and reporting system.

A fourth challenge arises from the fundamental limitations of financial statements in that they record past transactions and events and anticipate the future only to a limited extent. Therefore they focus too narrowly on the realisation of profits as a measure pay insufficient attention to the wider concept of increments in wealth.

There are a number of reasons why these challenges have emerged. First, there is the change in shareholder profile. The last few years have seen the growing emergence of institutional investors. In the U.S., the first pension fund was started in 1950 and by 1990, total institutional funds had assets in excess of $3.5 trillion and were growing at the rate of $1 to 2 billion per annum. Most of these funds are invested in the equities of corporations. In India also, the last few years since economic liberalisation in 1991 have seen the entry of foreign institutional investors whose current portfolio investments are in excess of $11 billion and the entry of private corporations into the mutual fund industry which today has investible funds in excess of Rs. 90,000 crores. These funds have also largely been invested in equities of corporations. There has therefore emerged a class of shareholders who are knowledgeable, conscious of their rights and willing to exercise them.

Second, as a society becomes more affluent it becomes more knowledge-based. In the last few years we have witnessed an increasing participation by a growing middle class in equity investments. This ``knowledge-based" class is thirsty for information and concerned about ethical matters. It wants to know whether the companies in which they have invested are pursuing sustainable development, respecting human rights and observing ecological standards.

Third, these new classes of investors are no longer content to use financial statements as historical accounts of stewardships but want to use them as the basis for making informed investment decisions for the future. In today's environment it is no longer possible to make informed economic judgments based on historical financial information as a much more complex set of factors affect value.

Fourth, there is the growing importance of the service sector which contributes over 50 per cent of the GDP in our country. Accounting practices were formed when manufacturing and trading activities were the dominant business activities and they still reflect that environment. The emergence of a 'knowledge-based' economy implies that it is becoming increasingly difficult to value companies reliably and accurately using traditional methods. Not only are an increasingly large proportion of the company's assets represented by intangibles, the company's fortunes can change quite radically and very quickly in the short run. Traditional accountancy is simply not equipped to cope with such rapid and discontinuous changes.

Last, there is the impact of globalisation. The "global village" has become a reality and countries are inevitably linked economically and financially. There is therefore increasingly felt the need for a common accounting language.

These challenges demand an effective and quick response from the profession. It is obvious that financial information will need to be supplemented by a large body of non-financial information. This information will often be in non-quantitative form and will involve value judgments on the part of the auditor. In order to be meaningful and consistent industry-based institutions will need to identify relevant non-financial performance criteria and to develop the best manner criteria can be measured. The profession can play a leading role in this exercise.

The valuation and presentation of intangibles is also attracting attention. The European Commission, the City University Business School in London, and the Brookings Institute in Washington are researching a form of financial reporting round a "statement of intellectual capital" to assess a company's performance in managing its intangible assets. The intention is that such a statement would not be constrained by existing accounting conventions but would still be subject to conventional disciplines and audit. A number of international accounting bodies are also examining the framework for managing and reporting intellectual capital. A single worldwide accounting language is fast becoming a reality.

Finally, the challenge of providing a comprehensive basis for the future value of an enterprise is the subject matter of an interesting project undertaken by the Canadian Institute. The project titled TVC (total value creation) attempts to design a set of financial reporting methodologies, embedded in computer software, which are intended to track and evaluate the critical events that can be said to create value within an enterprise. This will not supplant but will supplement the historical cost accounting system through a parallel but separate system that seeks to report the creation (as opposed to the realisation) of value. While traditional accounting is retrospective, TVC will be forward looking, based on the future and translated into values using DCF techniques. Initially it will be developed as an internal tool for management and an extension to an external audience can be considered thereafter.

The challenge of technology is perhaps the greatest facing the profession and failure to adequately respond to the challenge could even result in the destruction of the profession itself. The emergence of the Internet has significantly changed the manner in which companies do business, structure their organisation and operate their reporting systems and each of these pose serious challenges for the profession.

The first challenge arises from the increasing level of e- business. This is no longer confined to dot.com companies but is fast becoming an integral part of brick and mortar businesses. E- business creates a number of new business risks which the auditor needs to identify, example, (i) the risk of unauthorised access to and manipulation of applications and data by the large number of customers, suppliers and other outsiders who are given access to the system; (ii) increased credit risks as the volume of transactions significantly increase; and (iii) accounting issues related to income and expenditure recognition and allocation. Accountancy bodies all over the world are concerned with these risks and the consequent risks on the auditors and have issued standards and guidance notes on the subject. However, while it is certain that e-business will continue to evolve, no one knows quite how or what new issues will arise.

The second challenge which arises is from the changes in corporate laws in many countries which permit companies to distribute annual financial statements and other communications to shareholders electronically or through web sites. Allied to this is the growing awareness that out of date information and consequent uncertainty creates share price volatility. Markets need continuous reporting of performance and there are pressures on companies to provide information on a real-time basis. It is therefore possible that in the not too distant future, annual reports as we know them will disappear and be replaced by a constant stream of financial data accessible electronically.

An interesting development in this context is the emergence of XBRL (extensible business reporting mark-up language). Under XBRL, every element of a set of financial statements, operating and financial review or management discussion and analysis or any other piece of information that a company may wish to communicate is coded using a simple plain language tag. This universal coding allows companies and others to prepare, exchange and analyse corporate information in a consistent way and allows for the automated exchange and extraction of information among various software applications. This development could also facilitate process alignment between transactions from a web site to back office reporting systems.

An equally important development is the increasing use of shared service centres. Started in the U.S., the idea has rapidly spread to other countries. Under this concept all support activities in a particular field, example, financial services are consolidated into service centres to serve the business' commercial activities. The key drivers for all businesses are globalisation and consolidation and the latest technological advances enable the creation of such centres which do not have a physical location but are located ii cyberspace and accounting department which is a "black box'' hosted on the web.

A third challenge arises from the fact that the fragility of businesses will increase in the new environment. New technology brings new business risks and ultimately new financial risks. Faster developments in technology will encourage competition to develop and to do things faster, better and cheaper. Companies can more frequently get stranded in an obsolete business model and auditors will need to be particularly vigilant about considerations of ``impairment of assets" and the "going concern" concept.

A fourth challenge is that accounting will increasingly get centralised and information systems will be management-based with financial information for accounting becoming a mere by-product. Accounting locations, example, at branches of banks will significantly diminish, if not disappear as information will be directly fed into the system.

(To be concluded)

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