Duvvuri Subbarao: Challenges to the accounting profession - some
reflections
Inaugural address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
26th Regional Conference of the Western India Regional Council of the Institute of Chartered
Accounts of India (ICAI), Mumbai, 16 December 2011.
* * *
1. Thank you for inviting me to speak at this conference of the Western India Regional
Council of the Institute of Chartered Accountants of India (ICAI).
2. When I got invited to speak at this conference, at first I was a bit surprised. I
wondered why you might be wasting valuable conference time listening to the Reserve Bank
when there is not much in common between the Reserve Bank and the accounting
profession, except possibly the fact that we both lose sleep when numbers go wrong. I then
spoke to my staff and realized how wrong I was. We share considerable professional space
and have several mutual concerns. I will address some of those shared concerns.
3. Before doing so though, I must acknowledge another link between the Reserve Bank
and the accounting profession through Shri Y.H. Malegam, who has been a Director on the
Central Board of the Reserve Bank almost continuously since 1994 except for a brief interlude
of a few days. Shri Malegam is, by wide acknowledgement, one of the foremost Chartered
Accountants in India who has set very exacting standards of professional competence, and
more importantly, of professional conduct. The Reserve Bank has benefited enormously from
his vast knowledge of accounting, his understanding of the financial sector and his judgement
of the larger public interest. As a profession, you can all be proud of colleagues like Shri
Malegam who enhance public respect for the accounting profession.
The accounting profession
4. The development of the accounting profession owes its origin to the emergence of
the joint stock company and the consequent separation of ownership from management.
This arrangement triggered the need for an independent and informed opinion on the
accounting of the owners' funds entrusted to the management for their stewardship. The
"raison d'être" of the profession is consequently based on the confidence which the
profession enjoys with the investing public, and its continued relevance is essentially tied up
with retaining this confidence. While initially the profession provided this confidence only to
the shareholders of joint stock companies, today it provides this assurance to a wider base of
stakeholders including the government, the banking system, regulators and society itself.
5. At the Reserve Bank, we depend on the accounting profession for at least two
reasons. You audit the Reserve Bank's balance sheet of course, and you also audit the
balance sheets of commercial banks which we regulate and supervise.
Reserve bank's balance sheets
6. Let me make a brief comment here on the Reserve Bank's balance sheet. The
balance sheet of the Reserve Bank is different from that of commercial organizations in some
important respects. Uniquely, the Reserve Bank is statutorily mandated to have two balance
sheets - one for the Issue Department and the other for the Banking Department. The Issue
Department handles the task of issue, exchange and withdrawal of currency notes. The
Banking Department maintains the deposit accounts of banks and of governments. The
rationale for building a firewall around the balance sheet of the Issue Department is to
maintain the integrity of the asset backing for the currency that we issue. The firewall
ensures that the explicit promise that every currency note carries, which is to pay the bearer
the sum mentioned therein, is honoured in the full accounting sense. Our other balance
sheet, that of the Banking Department, reflects the transactions we perform in our role as
banker to banks and to the Central and state governments.
7. In the Reserve Bank, we are deeply conscious of our responsibility for maintaining
the integrity of our balance sheets. The Reserve Bank's balance sheets are analyzed by a
wide array of stakeholders to study the underlying monetary and macro economic trends so
as to make informed decisions. We have an obligation, therefore, to maintain the highest
standards of clarity, transparency and disclosure, and we try our best to meet this obligation.
RBI and the accounting profession
8. While the financial statements of the Reserve Bank are subject to audit by your
profession, as the regulator and supervisor of the banking system, the Reserve Bank is a
major stakeholder in commercial banks whose financial statements are audited by you. In
our view, auditors are the "eyes and ears" of RBI, and we trust them to alert us to early
warning signals to assist us in our supervisory process. We also encourage auditors to
discuss any regulatory issues with RBI before finalizing the accounts. Further, during the
process of "Annual Financial Inspection" of banks, the inspection team interacts with the
auditors to discuss issues of regulatory concern.
Challenges for the accounting profession
9. As several stakeholders depend upon the accounting profession, the profession too
has to recognize that it has to continue to inspire the trust and confidence of the stakeholders
if it has to remain relevant and value adding. In recent years, several challenges have
emerged, both at domestic and global levels which, if not effectively addressed, could erode
that confidence. Let me address what, in my view, are some of the key challenges.
Competence
10. First, the challenge of competence. With the growing complexity of the financial
sector and the emergence of new and sophisticated financial instruments, the knowledge
base of the profession needs to keep pace with these emerging practices and innovations.
This requires, not just a continual review of its curriculum, but more importantly, an active,
well diversified and constantly updated programme of continuing professional education for
its members. Continuing professional education cannot be a mere "tick in the box" or
determined by participation in number of hours of education or training, but should be
evaluated by way of outcomes - upgradation of relevant knowledge and skill sets.
11. Towards improving the skill set of the accounting profession, with particular
reference to auditing banks, the Reserve Bank has taken some initiatives. We have
established a practice of an annual Statutory Auditors' Conference to apprise the statutory
auditors of banks on the critical issues in the area of banking regulation and supervision. The
conference also provides a forum for auditors to give us their feedback on current concerns
and to suggest any changes to our supervisory and regulatory policies. We have found this
to be an effective forum for mutual exchange of views, and I hope you likewise have found it
to be value adding. I am open to suggestions on improving this engagement.
12. I am also happy to note in this context that as a result of your Institute's initiative,
India is embarking on convergence with International Financial Reporting Standards (IFRS),
which would then result in our financial accounting and reporting getting to be world class. As
you are no doubt aware, IFRSs are largely broad principles rather than detailed rules. Their
application requires judgment and possibly even lateral thinking, especially in the area of
determining the fair value of financial assets and liabilities. The auditing profession needs to
improve its skill endowment to facilitate a smooth and efficient convergence with IFRS.
Globalization
13. The second challenge the profession needs to reckon with is globalization.
Globalization implies that countries can no longer afford to remain isolated in so far as their
operating and legal systems are concerned. For the profession, this gets reflected not merely
in international accounting and auditing standards but also in a number of other areas like
education, ethics, etc. I gather the ICAI, with its 180,000 members, is the second largest
accounting institution in the world. It is not sufficient that the Institute merely responds to and
adopts global standards. It should, in fact, go further and actively participate in the
formulation of these standards.
14. I am happy to learn that the President of ICAI has recently been elected as a
member of the board of the International Federation of Accountants (IFAC) and that there is
an Indian member on the IASB. I also want to commend the Institute for its active
participation and involvement in several international committees and projects aimed at
improving accounting systems and processes. I would only urge that going forward, ICAI
should proactively take the lead in the formulation of accounting standards in areas where
we have specific concerns as an Emerging Market Economy (EME).
15. Another task the profession needs to address in regard to managing globalization is
how it will select, from within its membership, persons of the requisite competence to
participate in the global forums, and how it will provide them both financial and professional
support to make this participation rewarding to them individually and to the profession more
broadly. Needless to say, the process of selection of persons for representing the Institute in
international forums should be strictly meritocratic and transparent.
Information Technology (IT)
16. Next on my list is the challenge of Information Technology. In the past, one of the
main objectives of audit was ensuring the arithmetical accuracy of financial statements. With
the advent of IT, this task has now been taken over by machines. This has both nudged and
facilitated the profession to move up the value chain. The main task of the profession has
now shifted to judgments of value, and to discharge this task, auditors have to demonstrate
much higher levels of maturity, integrity, independence and balanced judgment. The
development of these qualities will be a major challenge in the future.
17. Let me make a comment with regard to IT in banking. Over the past decade, most
commercial banks have successfully implemented core banking solutions. This has created
both opportunities and challenges for auditors. Challenges come by way of lack of visible
evidence, risk of undetected system errors and bugs and frauds hidden in a labyrinth of data.
Retrieving information in the computerized environment and assessing the implementation of
computer related processes will also be critical to the audit process. Opportunities come by
way of increasing use of Computer Assisted Audit Tools (CAATs) to access databases
beneath the accounting software to create queries, write reports and develop audit trails.
While the profession has risen to the challenge of auditing banks in an IT environment, we
need to explore further on how audit can overcome the challenges and exploit the
opportunities of the IT environment to make audit of banks more effective and meaningful.
Opportunities
18. I am told one of the issues agitating all of you is expansion of opportunities for the
accounting profession especially in view of the growing membership of the Institute. So far,
you have enjoyed a monopoly position in respect of certain areas of work, for example, the
audit of financial statements. The easy way out to seek and expand opportunities would be to
agitate for continuation of this monopoly position. I believe this will be a mistake. Rather, the
profession needs to identify emerging opportunities in the market place and develop the skill
needed to exploit them.
19. Let me cite an example. With concepts like core banking and centralized record
keeping, the relevance of the audit of branches of Public Sector Banks (PSBs) has
significantly declined. These banks have represented to RBI that the audit of bank's
branches should be reduced. There is merit in this suggestion, since currently the cost of
audit of PSBs is significantly higher than the cost of audit of comparable private sector
banks. However, the Institute has been resisting this because it would mean a reduction in
work for its members.
20. I believe the Institute's efforts in this regard are ill advised. In fact, it makes much
more sense for the profession to sharpen its skills in the area of concurrent audit for which a
need exists than to agitate for retention of work which does not add value. Similarly, the
profession has shied away from the responsibility for prevention and early detection of fraud.
The need for such a service exists and if the profession does not fulfill that need, other
agencies which can provide this service will displace auditors and deprive them of a
potentially expanding opportunity.
Independence
21. Let me now turn to the challenge of "independence". The growth of large
international firms of accountants has created an opportunity for the provision of a multiplicity
of services. Clients benefit from such umbrella services and attach value to it. However, this
also raises the vexed question of the extent to which provision of these multiple services
erodes the concept of independence.
22. The case of Enron, which took down along with it the audit firm Arthur Andersen,
comes to mind in this context. The sudden collapse of Enron, an energy trading and
distributing company, ranked seventh in the Fortune 500, raised a number of questions about
the accounting and auditing practices followed by the company. The company used creative
accounting to shift losses and debts off the company's balance sheet into special purpose
entities (SPEs) thereby concealing the extent of its indebtedness. The company was also
reported to have withheld information about SPEs which could have led auditors to insist on
their consolidation in the balance sheet. Enron's accounting transgressions misled investors
to believe that the company was more profitable and less leveraged than it really was.
23. Andersen audited Enron for all sixteen years since the company's formation. On top
of pure audit, it also sold internal-audit and consulting services. Despite this privileged
insight, Andersen did not discover that Enron was publishing incorrect financial statements
leading to the term "Enronisation of financial statements". This raises an important question
of conflict of interest. Is it the case that the extensive consultancy work done by Arthur
Andersen for Enron compromised its independence leading to its failure to detect erosion of
accounting standards? It also subsequently came to light that some members of the Audit
Committee faced financial conflicts of interest, generated in part by the company's donations
to charities to which they were connected. Could this conflict have been prevented?
24. Accounting and auditing practices were also called into question in the collapse of
Parmalat, the largest dairy company in Europe, in one of the biggest accounting frauds in
corporate history. Like Enron, Parmalat too undertook elaborate derivative deals, often using
complex offshore structures that involved some of its many subsidiaries. Investors and
bankers struggled to understand the balance sheet or gauge the true extent of its liabilities. By
the time it collapsed, Parmalat had established dozens of arrangements involving offshore
companies, which did not form part of the company's consolidated financial statements.
25. Instances such as these reaffirm the need for systemic reforms in two areas. The
first is the regulation of auditors. The profession has argued for years that self-regulation and
peer review are the right way to maintain standards. But the conduct of Enron, Parmalat etc.
under the very nose of auditors has raised question about the effectiveness of soft
regulation. The profession has to find a way of remedying this if it wants to prevent the
imposition of an external regulator.
26. The second reform is the need to eliminate conflict of interest in accounting firms.
Should there be a ban on auditors selling consulting services to those they audit? One view
is that there is no real conflict of interest and that better audits would be the best way to
assure regulators that such a ban is unnecessary. Yet if confidence in auditing is to be
regained, perception is equally important. Regulators are likely to demand some meaningful
change on the issue of such conflict of interest. Overall, this is a complex issue which needs
to be addressed dispassionately.
Inter-disciplinary approach
27. Inter-disciplinary approach is the next challenge on my list. In a complex world, no
single profession can meet all the requirements of market participants. Neither is it possible
for individual professions to operate in silos catering to specialized needs. Inter-disciplinary
interaction is therefore not only unavoidable, but in fact desirable. But this creates its own
problems, particularly in the area of disciplinary jurisdiction as professional standards in
different governing bodies - if such a body exists - may be different and members of such
bodies may be differently regulated.
28. The recent global financial crisis illustrates the problems that can arise from
divergence of views across disciplines - in this case between the accounting profession and
prudential banking regulators. There is widespread criticism that the accounting standards,
more so fair value accounting insisted on by accountants, failed to reckon with illiquid
markets and distressed sales, and thereby contributed to the crisis, or at the very least
exacerbated the severity of the crisis.
29. Post-crisis, there is convergence in the views of prudential regulators and
accounting standard setters on the desirability of forward looking expected loss approach to
loan loss provisioning. The IASB, FASB as well as the Basel Committee on Banking
Supervision (BCBS) are actively engaged in finding a commonly agreed solution to this
complex problem.
30. While discussing the issue of loan loss provisioning, I would like to highlight the
Reserve Bank's concern on the issue of divergence in identification of Non Performing
Assets (NPAs) and provisioning as certified by statutory auditors vis-a-vis the findings of the
supervisory inspection conducted by RBI. In the Reserve Bank's view, in certain cases, the
statutory auditors have underestimated the extent of NPAs and the required provisioning.
Since RBI, as the supervisor of the banking system, relies and leverages on the work done
by auditors, the profession should effectively address this issue. Ultimately, it is the statutory
auditors' certification that is taken as the "true and fair" statement of the accounts of a bank
and is disclosed to all stakeholders. It is therefore of prime importance that there is no
underestimation of provisioning requirements while finalising financial statements of banks.
Value systems
31. Finally, let me turn to the sensitive and important issue of a value system. Recent
months have witnessed an agitation across the country about erosion of values in the public
domain. The norms of a society are determined by the dominant sections of that society, and
the accounting profession is certainly a dominant section of society. The value system you
practise in your professional conduct influences the value system of the society. Sadly, we
see several transgressions.
32. Take the case of Worldcom. Worldcom indulged in major accounting misstatements
which hid the precarious financial position of the company. Investigations revealed that more
than three billion dollars worth of costs were wrongly classified as capital expenses over a
five quarter period. This boosted the reported profits, which were in fact fictitious.
33. The case of Satyam Computer Services here in India was similar. The company's
chairman confessed to more than a billion dollar fraud on its balance sheet which was hidden
from the company's board, its senior managers and of course the auditors for several years.
The truth followed a now familiar pattern - overstating profits, understating liabilities, and
overstating cash causing a big hole in the balance sheet.
34. With so much accounting misconduct in big corporations, stakeholders wonder why
books are not being reviewed on the default assumption that there could be fraud afoot.
Accounting experts explain that the kind of forensic auditing that reconstructs fraud is so
time-consuming and expensive that it could bring an honest business to its knees. However,
I strongly believe that a robust system of audits, a corporate culture in which ethical conduct
is encouraged and exemplified and an active and independent Board of Directors can make
such frauds harder to perpetrate, easier to detect and help restore public confidence in
published results.
35. What has been RBI's contribution in this regard? Recognising the importance of the
internal audit and inspection function as an effective management tool, in April 1994, the
Reserve Bank advised all banks to set up an Audit Committee of the Board (ACB) of
Directors. Needless to say, we need to have skilled and qualified persons on the ACBs to
make them truly effective. Accordingly, in September 1995, we advised banks to ensure that
there is at least one non-executive director who should be a Chartered Accountant on the
ACB. ACBs have since been contributing immensely by providing direction and also by
overseeing the internal control function in the bank. We have kept the CEO of the bank
outside the ACB to keep it independent. However, the second in command, the Executive
Director concerned is a member of the ACB to bring the insider perspective to bear on the
Committee's deliberations. However, the presence of an executive director may be seen on
compromising the independence of the ACB. I will be interested in your views on this.
36. Returning to the larger issue of a value system, the challenge before the profession
is therefore to demonstrate by its own conduct, its concern for upholding a value system
within itself and consequently within its clientele as also to initiate programmes which create
sensitivity to the need for greater ethical conduct. In this context I would only like to reiterate
that you have a significant role as the conscience-keeper of the business world.
Conclusion
37. Let me now sum up. I have started with briefly identifying the shared professional
domain of the auditing profession and the Reserve Bank. I have alluded to the uniqueness of
the Reserve Bank's balance sheet, or indeed balance sheets. I then went on to indicate,
what in my view, are some of the key challenges that the profession has to address in order
to remain effective and to add value to the real sector. Where relevant, I have given
contextual references and illustrations from the Reserve Bank, particularly stemming from its
role as the regulator and supervisor of the banking system.
38. I wish your deliberations over the next two days all success.