Wednesday, October 11, 2017

True and fair view

Ensuring that financial statements give a faithful account of the economic performance and well-being of a firm lies at the foundation of corporate financial reporting. Indeed, the nineteenth century British law which first allowed companies to be incorporated through registration rather than through royal charters or acts of parliament—the Joint Stock Companies Registration and Regulation Act of 1844—also required these companies to prepare a ‘full and fair’ balance sheet. Another founding legislation, the UK Companies Act of 1900, required auditors to report whether the balance sheet exhibits a ‘true and correct’ view of the state of the company’s affairs. Today’s regulatory practices continue to aim at the same goal of ensuring transparency and unbiasedness in accounting.
            However, regulators face a dilemma. Ensuring faithfulness requires the framing of rules and guidelines for accounting. Yet, a rule which is too strict may fail to capture the essence of an economic situation when applied in settings not foreseen by the framers of the rule. Moreover, as business becomes more complex, unscrupulous entities can actually exploit such narrow rules to fulfil the letter of the law while defying its spirit.
            An early statement of this dilemma can be found in the Institute of Chartered Accountants of England and Wales’ demand for an amendment in the “true and correct” requirement of the Act of 1900. They said, “The word ‘correct’ has always been too strong because it implies that there is one view which is ‘correct’ as against all others which are incorrect. In published accounts there is no standard of absolute truth and the Institute’s suggested amendment would recognise that the presentation of figures can only be that which a fair view is, in the personal view of the auditor,” (The Accountant, 1 July 1944, p. 2). Following this, the term ‘true and fair view’ was introduced in British legislation through the Companies Act, 1948.
            The Indian Companies Act too imposes a general requirement that financial statements give a true and fair view of the state of affairs of the company and its performance. Schedule III of the Act provides the format for the presentation of balance sheet and stipulates principles for the preparation of balance sheet and profit and loss account. But adherence to the disclosure requirements is subservient to the overriding requirement of “true and fair”, and departures from schedule III are allowed if that is necessary in order to give a true and fair view.
            True and fair view expresses a broad philosophy which cannot be restricted by a specific legal definition. Rather, the need is to understand the spirit underlying the concept. The general understanding is that “true and fair” implies that financial statements should not only be made out correctly, but they should convey an overall fair view and should not give any misleading impression. There should be transparency in reporting the financial position and working results.
            But in practice, accountants take a narrow view of the concept of true and fair. According to them, financial statements give a ‘true and fair’ view if, they are free from any material error or bias, and that they are prepared and presented in accordance with legal requirements and by applying the accounting principles and methods stipulated in various accounting standards. Auditors do not take into account whether any disclosure beyond the minimum required by law and accounting standards is required for financial statements to give a true and fair view and whether voluntary disclosures are adequate. Moreover, accountants and auditors are reluctant to deviate from the principles and methods set out in accounting standards even if there are strong indications that application of accounting principles other than those stipulated in accounting standards will improve the presentation of financial statements.
            The Companies Act too requires that every profit and loss account and balance sheet shall comply with the accounting standards and any deviation from the accounting standards should be disclosed along with the reasons for deviation. It does not make it clear, as in the case of Schedule III, that true and fair overrides the requirements of accounting standards. Courts usually take the view that financial statements drawn up in accordance with legal requirements and generally accepted accounting principles (GAAP) present the true and fair view. Thus, for the legal systems accountants and auditors, true and fair view has become subservient to accounting standards.
            In 1988, a strong dissent was made against this by Sir David Tweedie, the past Chairman of the International Accounting Standards Board (IASB), when he was the Chairman of the Accounting Standard Board (ASB) of UK. He stated, “In its progressive form it (true and fair view) can be used to replace antiquated laws and indeed outdated accounting standards prior to their revision.” Regulators might not agree with this progressive interpretation. Allowing companies to apply the true and fair view concept without any bound, such as the one being imposed by accounting standards, provides huge opportunities for creative accounting. Therefore, it is unlikely that the true and fair view will override accounting standards.
            This leads to a more fundamental question. What should be the bounds or limits that should be imposed by accounting standards? At one extreme, we may live with only the conceptual framework which sets out the fundamental accounting principles relevant and appropriate in the present-day context and replaces the bunch of accounting conventions. At the other extreme, regulators may issue rules-based accounting standards. In between the two extremes lies principles-based accounting standards. The moot question is how much flexibility should be provided to accountants and auditors in deciding the accounting policy. Too much flexibility is as bad as too little flexibility. In this, principles-based accounting standards strike the right balance.
            There is a need to change the perception that a standard that permits fewer allowable alternative accounting methods is superior to one that permits more alternatives. If we accept the paradigm that accountants and auditors should be provided adequate flexibility to formulate accounting policy, taking into consideration specificity of transactions and the nature of industry, an accounting standard that permits adequate number of alternatives should be considered superior to the one that provides no alternative. Ideally, an accounting standard should clearly articulate the objectives of the standard and stipulate accounting principles without detailing the rules. Examples may be given to explain the principles. This will provide enough flexibility to accountants and auditors to apply the concept of true and fair view and formulate appropriate accounting policy based on stipulated accounting principles. Accounting bodies should refrain from issuing large number of interpretations and opinions. For example, the Institute of Chartered Accountants of India (ICAI) should stop providing expert opinion on accounting for transactions specific to a particular company. Although much lower in hierarchy than accounting standards and other technical pronouncements, they become a part of the rule book and a reference point for accountants and auditors and reduce the desired flexibility in formulating company-specific accounting policy.

            The proposed approach will reduce the work of standard setters and they will find it difficult to justify their present organisational structure. But that should not be a consideration in reforming the format of accounting standards.

Kotak Committee Report on corporate governance was not needed - my interview in ET CFO

Q: What are your broad views on the Uday Kotak-led panel report on corporate governance?
AKB: Although the panel has made many important recommendations, which are conceptually sound, I think, this report wasn't needed in the first place. We came upwith the Companies Act in 2013, and then Sebi Listing Obligations and Disclosure Requirements (LODR)Regulations in 2015. And it has been just two years since then that we came again with the new recommendations. The question that arises is that are we really going to bring new regulations so frequently to improve corporate
I believe present laws are enough to improve corporate governance. We should let them stabilise first, and try to make companies apply them in spirit. For this, a change in mind set is extremely important. In absence of that, companies will continue to adopt the 'tick box' approach to corporate governance.
Q: On the Board structure the Kotak Committee recommends a minimum of 6 directors for listed companies? How do you look at this suggestion?
AKB: Usually the average size of the Board in India is between 8-9 directors and therefore for large companies this is not at all an issue. But for smaller companies (bottom 2000 companies) this might be a problem. Their compliance cost will increase.
Q: What do you make of minimum Rs 5 lakh annual remuneration and Rs 20,000-50,000 sitting fees for
independent directors?
AKB: The panel has recommended minimum compensation for top 500 companies. The minimum
remuneration for independent directors is not required. Independent directors, who are accomplished individuals in their own field, are not driven by monetary incentives.The risk is that those who are not accomplished will compromise on independence. I believe, as is the case at present, the board should decide the sitting fees and the commission.
Q: The panel also recommends at least one independent woman director and talks about splitting
the MD/Chairman posts...
AKB: My observation is that the report on board structure and other things are really not important. Because provisions in the Companies Act and Sebi's LODR are enough for improving corporate governance. The panel has recommended that at least one womandirector should be independent, but why? There can be one logic that is if the woman director is related to the promoter, she might carry the opinion of the promoter, and not share her independent views instead. Therefore thebenefit of gender diversity may not come. But we are stretching our assumptions. These are general beliefs. There is no research to say that an independent women director is contributing more than non- executive women
director or executive women director. This doesn't serve much purpose in terms of merits. If the culture in the Board is to allow free discussion and a virtuous cycle is created that is there is mutual trust
between the Board of Directors, then even the executivewoman director will be able to bring her point of view. It all depends on the company's culture and the Board culture. Second, you are again compelling the bottom 2000 companies to appoint someone as woman independentdirector on their Boards when there is already a scarcity of independent directors with right credentials.
Likewise the panel has talked about dividing the position of Chairman and MD but they have not said independent director should be the chairman, they have said nonexecutive director should be the chairman. Now, in the Nifty 50 companies, over 30-35 are run by family businesses and most of them have non-executive chairman, who is either promoter or related to the promoter. In those companies, the CEO and the chairperson positions are separated. But is the CEO independent of the non-executive chairman, the answer is no. Again the control is tilted towards the executive management. The panel has recommended that if the chairman is not an independent director, lead independent director should be appointed. This concept is good. But, the effectiveness depends on the 'independence of the independent director'. Today, in most companies, NRC (Nomination and
Remuneration Committee) is not effective. No independent director is appointed without the tacit approval of the controlling or dominant shareholder. This is unlikely to change unless the mind set of such a
shareholder changes, even if majority of the members of NRC are independent directors, as recommended by the panel.
Q: The panel has emphasized a great deal especially on the role of Independent Directors.
AKB: I believe that independent directors in family run businesses can't improve Board's effectiveness in
oversight function. They improve Board's effectiveness in advisory function. They can check and protect minority shareholders from direct fraud. But they do not engage effectively with management in deciding the strategy and other important issues. It is the promoter who invests most of the family wealth in the company and brings funds in crisis situations by providing personal guarantee. Such a promoter would find it difficult to effectively engage independent directors in decision-making, unless he or she sees value in the same. Hence, a change in mind set is more crucial in improving the effectiveness of boards and independent directors.
Q: The panel also talks about the number of times the Board should meet in a year. How important is this?
AKB: The panel recommends that the Board should meet at least five times in a year. At present, the requirement is four times in a year. Usually, in large companies the Board meets more than four times in a year depending on the issues before it. For small companies, increase in the number of meetings will increase the compliance cost. I think that the current requirement is adequate.

Wednesday, August 16, 2017

Anil Kumble's resignation - A governance issue

Anil Kumble resigned from the position of Head Coach of the Indian (senior men’s) cricket team in June 2017, because Virat Kohli, the captain of the Indian team and some team members did not like his style of working and the relationship between the captain and the coach became ‘untenable’.  It is not for the first time that the head coach of the Indian team had to leave the job for differences with  the captain.   
The head coach’s responsibilities include developing the overall coaching plan and monitoring the performance of the coaching staff, finalising the playing eleven and formulating strategy in consultation with the captain before a game and ensuring that fringe payers are ready to take the field when required. The head coach should be able to take a position and advise the captain if he is wrong.
If, we go by the writing of cricket journalists, the head coach of the Indian cricket team survives only if he gives freehand to the captain in selecting the playing eleven and formulating strategy, and goes soft with the captain and star players. In Indian cricket, head coach is placed a rung below the captain. Some argue that it should be so, because cricket is a ‘team game’ and the team belongs to the captain, who leads the team in the field and formulates strategy under pressure during the game. However, others differ.
The relationship between the captain and the head coach is similar to the relationship between the board of directors (hereafter board) and the CEO.  In cricket, the goals of both the captain and the head coach is the same, which are to win matches and to build a team that will continue to win matches. Similarly, the goal of the board and the CEO is the same, which are to achieve vision and mission of the company and to continuously create shareholder value, while being compliant to applicable laws and social norms. As in cricket, the relationship between the CEO and the board comes under stress when the board engages with the CEO in the management of the company. Often, the CEO perceives it as intrusion in his/her territory and interference.
The key question is what should be the level of the engagement of the board in the management. It is determined by the environment, in which the company operates, and board’s power and knowledge.
In cricket the engagement of the head coach in the management of the team is likely to be high for a team, which plays large number of matches every year in different locations, like the Indian cricket team, because players suffer injury and sometimes star players are to be counseled to sit out based on the ground condition or his fitness or form. Similarly, board’s engagement in the management should be high in a company that is operating in VUCA (volatile, uncertain, complex and ambiguous) environment or is going through a crisis.
The board gets the power from the laws and regulations, and the articles of association. In Indian cricket, the head coach lacks power because the Board of Control For Cricket in India (BCCI), in practice, has placed the coach one rung lower than the captain. The situation is reverse when it comes to knowledge. The head coach has an expert knowledge of the game. Unfortunately, most boards lack adequate knowledge.  Exemplary boards ensure that the board has adequate knowledge by selecting right individuals as directors and through training.
If the coach fails to engage in team management, ultimately the team suffers. Similarly, if the board shies away from engaging in management when required, ultimately the company suffers. An exemplary board supports CEO, but also intervenes, when required and before it is too late.
The relationship between the board and the CEO should be that of trust. Exemplary boards develop corporate governance policy, in consultation with the CEO, in order to maintain healthy relationship between the CEO and the board. It is usually in writing. It clearly articulates areas that are reserved for the CEO and those that are reserved for the board and the expected level of engagement of the board in management. For example, it may articulate in detail the board’s involvement in crafting, implementing and reviewing strategy.
It will be good for the Indian cricket if BCCI develops a document like corporate governance policy and place the coach a rung higher than the captain, as it is in other sports. Managing business is a ‘team game’ and the board is placed a rung higher than the CEO.  

Monday, July 10, 2017

Should employees get primacy in corporate governance?

Large number of jobs in the Information Technology (IT) sector is at stake. Automation and new technology are disrupting the industry. Skills that created value so far are becoming redundant. New skills are required to work with new technologies, such as, Big Data, artificial intelligence, Internet of Things, robotics and virtual reality. Companies have started up-skilling existing employees and recruiting those with required skills. Employees, who are unable to acquire new skills, are losing jobs.
In the above context two questions have emerged. The first question is whether it is better for the top management to take pay cut rather than to layoff employees in difficult years. The other question is whether IT employees should form union to protect their interest when the going is tough. The first question is relevant when the job loss is due to a slow down, which is transitory. In that situation, the pay cut by the top management will be for a short period in order to retain the talent that will be used after the bad period is over. It is not relevant when jobs and skills become redundant due to disruption caused by technological advancement or some other mega event. The second question is relevant in all situations from the perspective of employees. Bargaining power is relevant in all types of negotiations and collective bargaining is desirable when individual bargaining power is low. Protecting the job during tough times or securing adequate compensation when a job is lost requires hard negotiation with the employer. Therefore, it is no surprise that employees, including IT employees, have the propensity to form union.
There are no straight answers to both the vexed questions. 
Although the IT industry is in focus at present, such disruptions occur in almost all industries with fast changing technological, social and geo-political environment. Therefore, it is appropriate to examine the issue from the perspective of corporate governance.
Companies create value through its operations while complying with law and social norms, and taking care of the social and environmental concerns. A very small portion of the value is shared with socially and/or economically marginalised population of the society through Corporate Social Responsibility (CSR). Shareholders, customers, providers of inputs (including human capital and debt capital), and government share the value created by the company. Government gets its share through direct and indirect taxes. Companies, through industry associations or otherwise, lobby with governments to reduce their share of the value. The share of customers and input providers in the value created by the company depends on the market forces and their relative bargaining power vis-à-vis the company. The share of shareholders is the residual amount. Shareholders’ primacy is well established in corporate governance. Therefore, companies focus on creating ‘shareholder value’ while being ethical and fair to other stakeholders. There are two reasons for the same. First, financial capital is sticky in the sense that once invested in non-financial assets (such as, plant and equipment) to build capacity, it cannot be recovered without substantial loss. Second, the non-controlling shareholders after entrusting their fund to the company cannot participate in strategic and operating decisions. In absence of focus on creating ‘shareholder value’ and effective monitoring, the management might misallocate the resources causing depletion of shareholders’ wealth permanently.
Human capital is also ‘sticky’ like financial capital. After completing substantial period of employment in a company, employees develop specialised skills, which are not useful in other industries. Consequently, their market value outside the industry is very low, almost zero. Similarly, when business model or technology changes many of those skills become redundant. Therefore, those who lose job due to change in the business model or technology cannot find an alternative employment. In this context it is important to consider whether employees should also be considered as a primary stakeholder along with shareholders. Companies should focus on both ‘creating shareholder value’ and ‘protecting and creating employee value’.
It is not enough to merely honouring the initial employment contract with an employee. It is important that employees are trained to acquire skills that would be needed in future, when the company sees disruption coming, that is, much before the disruption occur or the company plans to change the business model. Companies should ensure alternative livelihood for those who cannot acquire new skills, particularly if they are low-paid employees.
The issue is complex, particularly because companies engage large number of employees on short-term contracts and off-role. It deserves serious debate among academicians, regulators and practitioners of corporate governance.

Tuesday, June 13, 2017

Is investing in tobacco business unethical?

The Bombay high court will hear a Public Interest Litigation (PIL) filed by two Tata Trusts trustees along with five others against the union government, the Insurance Regulatory and Development Authority of India (IRDAI), LIC and other state-run insurance companies. The PIL called on the high court to direct the public sector insurance companies to divest their shareholding from the companies that are directly and indirectly engaged in the tobacco businesses. The PIL argues that investment by those companies in tobacco business is against the spirit and intent of the World Health Organization’s Framework Convention on Tobacco Control (WHO FCTC), which is the health treaty developed in 2003 in response to the globalization of the tobacco epidemic. India became a partner of the treaty in 2005.
Tobacco consumption causes estimated six million deaths per year globally, of which one million are in India.  The production-related health hazards from tobacco are also a matter of serious concern. Tobacco farmers, farm-workers, and bidi workers suffer from occupational illnesses like ‘green tobacco sickness’ (GTS).  Tobacco consumption also has severe societal costs due to reduced productivity, health cost burden and environmental damage.
The government, in conformity with WHO FCTC, has framed laws and taken steps for reducing tobacco consumption and creating awareness about health hazards. It is also working on reducing tobacco farming by developing economically beneficial alternative crops and vocations for tobacco farmers. Results are visible, although the progress is quite slow.
In spite of the disastrous health hazard from tobacco consumption, an average investor would consider including investment in a company that is in tobacco business in her/his portfolio of investment. An average investor behaves rationally. Therefore, so long as she/he estimates that the company would continue to create shareholder value, she/he would consider investing in the company. She/he uses ‘environmental, social and governance’ (ESG) criteria to assess business risks of the tobacco business (say, risks from tighter government regulations, falling sales volume and activism against tobacco consumption) and factors in the same in valuing the company’s equity.
Is there any ethical or moral issue in investing in tobacco business, which is a legal activity? Ethical considerations transgress the legal boundary. Therefore, some argue that it is immoral and unethical to invest in the production and sale of those products, the production and/or consumption of which harms the society. ‘Ethical investing’ (also called socially responsible investment, or sustainable, responsible and impact investing) is an old concept. Ethical investing requires using ESG criteria, in addition to financial criteria, in deciding investment in a particular industry or a particular company. It uses ESG criteria not to assess business risks, but to assess impact of the business on environment and society. Investors who believe in ethical investing would not invest in so-called ‘sin’ industries (e.g., tobacco, alcohol, gambling and military weapons), the products or processes of which, in their judgement, are harmful to the environment or society.
I think whether to invest in companies operating in ‘sin’ industries is a matter of personal choice based on one’s own individual ethical standards. For example, an oncologist, who experiences the trauma of her patients, may believe that investment in tobacco business is unethical. Similarly, ethical standards of individuals are often developed based on prescriptions and proscriptions in scriptures of their religion. However, in general, it is not immoral to invest in a company, which is allowed to operate by the parliament, even if it operates in a ‘sin’ industry. Parliament, in its collective wisdom, allows certain business activities and prohibits some others after taking into consideration public opinion and socio-economic impacts and weighing social costs and benefits of a particular business activity at a particular point in time. For example, in 2016 the central government issued complete ban of manufacture and sale chewable tobacco and nicotine, while it continues to allow production and sale of other tobacco products like cigarette and bidi. Parliament, by allowing a business to operate, conveys social approval to the business. Investing in a company, which is engaged in a legal business and complies with applicable laws (including soft laws) and social practices, is not unethical, because it passes the ‘social legitimacy’ test. Rather, it is unethical to invest in companies, which adopt unethical practices and flout regulatory and social norms, irrespective of the industries in which they operate.
It is inappropriate to restrain the government or PSEs from investing in companies like ITC, which provides superior return on investment. LIC, as a custodian of policyholder’s money, should act like a rational investor in building the investment portfolio.