Thursday, 22 September 2016

Whose Interests Should the Accountancy Profession Protect?

As usual the issue of maintaining audit as a mandatory requirement for all limited companies who get attraction at the Malaysian Institute of Accountants (MIA) annual general meeting.

It appears that instead of taking advantage of the requirements of the law, many auditors feel that mandatory audit is a sort of rights and any attempt to relieve small companies from such requirement should be opposed. The following motion would be debated at the forthcoming MIA annual general meeting this Saturday:

MOTION 2:

BE IT RESOLVED THAT the Malaysian Institute of Accountants (MIA) expresses its members’ intention to the relevant government authorities that audit exemption be limited to dormant companies only. And, to request the Companies Commission of Malaysia (CCM) to engage with MIA before confirming the guidelines on the companies to be exempted from audit. 

There are a number of public interest issues behind this discussion:
  1. Exempting from audit is practised in many countries recognising that audit is only valuable when companies have grown to a certain size. Why should Malaysia be different?
  1. Auditing standards, especially for private companies, generally are not up to the mark. As of 30 June 2015, out of 660 firms which were reviewed by MIA, 47% did not meet MIA own auditing standards (Type 3). This is a serious situation if considered from public interest perspectives. Were the clients of those firms which got Type 3 did not get their fair share of the bargain? Were there assurances, as expected by auditing standards, for those audit engagements? Interestingly, in the 2016 annual report, the statistics on the outcomes of practice review is not shared? The closest to this were the number of practice review failure cases which were referred to the Investigation Committee. 26 cases were referred!
  1. The MIA allows auditors in Malaysia to limit the usage of their audit reports to the shareholders of the companies only. While the legal position of this limitation has yet to be tested in Malaysia, the issue is whether such limitation is fair given that audit requirements is mandatory.
MIA is not a trade association. It is a body set up by an act of parliament to safeguard the accountancy profession and public interests. Section 6 of the Accountants Act requires MIA to regulate the practice of accountancy in Malaysia. Who are at risks when MIA members do not perform their work according to the standards set by MIA itself? It is obvious, the party which need protection is the public who are not in the position to assess the quality of work including those performed by auditors.

If the rate of sub-standard assessment is very high, what were the remedial measures done? All auditors would claim in their audit report that they have complied with the auditing standards, the MIA own practice review results indicate a high non-compliant rates. More information should be share, for the sake of the public who consumes the services of MIA members, especially auditors.

Sir David Tweedie, the former Chairman of the International Accounting Standards Board was in KL earlier this week. His advice to the accountancy profession was "You serve public interest first, then your profession, client, employer and your self". I trust this advise would be upheld by MIA.

Let's see what would transpire at the MIA AGM and see whether public interest becomes the overriding principle in the decision to be made by a profession which has legal backing for its existence.

Saturday, 6 August 2016

How Is Your Board Dealing With Brexit?

Even as the votes were being counted on June 23, not many people in Britain and the whole world were expecting that the ‘Leave’ side would prevail during the recent referendum to determine whether the UK should remain in the European Union (EU) or otherwise. However, as more votes were counted later that night, the concern about something not imaginable started to become stronger. The pound started to tumble against many currencies. By the morning the day after, the ‘Leave’ campaign had won.
Brexit or Britain exiting the EU appears to be a classical black swan event, something not foreseeable to happen which eventually happened. Not only did the event split British voters into two groups, ‘Remain’ and ‘Leave’, but it also brought with it uncertainties which would persist over a long period.
The first casualty was David Cameron, the British prime minister who had to quit his job after being defeated during the referendum. His successor, Theresa May, who was from the ‘Remain’ camp, has to take over and deal with something which she herself was not convinced is good for the UK and Europe as a whole. While she had clarified that the UK would only invoke Article 50, the trigger for exit, towards the end of the year, many people are still hoping that Brexit would never materialise. Some people are even bringing this issue to court.

The Europeans would also try to make Brexit as tough as possible to deter other countries within the union to venture into the same territory. Strong remarks from Brussels and Berlin in urging for the UK to invoke Article 50 as quickly as possible could also be aimed at other member states as well in sending the message that this is not a game.
While uncertainties could be good for speculators and some could have made money in the financial markets after the Brexit decision, uncertainties would also influence sentiments and confidence of investors. There are already talks about investment moving away from the UK to other parts of the world. In the stage where the global economy is not at its optimum as what we would have liked, a black swan event like Brexit is the last thing that we need.
While many Malaysian companies may not have direct exposure to the risks arising from Brexit, this issue should not be left unattended. The risks could also be possible from secondary events such as new rules which could be applicable once the UK is no longer part of the EU. Market access to Europe, for example, could be affected if the existing entry point is only from the UK. Effects on customers or particular market segments have to be considered and even the reliability and cost effectiveness of any supply chain from the UK or Europe has to be reviewed again.
On the other hand, would there be new opportunities as well? If there are really capital flights from the UK, would there be any chance that Malaysian companies could have some share of that? What needs to be done to capture those opportunities?
It is well known that some Malaysian companies were investing heavily in the UK property sector in the past few years. For them, their exposure to the risks of Brexit is different; some of the risks could have already crystallised. If the progress of their property development projects, for example, is already half-way through, the next course of action would be vital. Do they proceed as planned, defer further investment or speed things up, pack their bags and leave the market? All these options and their consequences require deep thinking to figure out some sense of direction and logic that correspond to the realities on the ground.
While many companies are aware about what is going on around them, not many are taking those events seriously. In the absence of a systematic process where events are detected and analysed and the understanding of their impacts are discussed in C-suites and boardrooms, many clear and present dangers and opportunities would be missed. This is where board members have to be comfortable that the companies under their care regularly scan the local, regional and global landscapes to detect and analyse emerging trends and update them accordingly.
For the case in hand, it would be also good to reflect on whether the processes had detected the possibility of Brexit and whether the views formed were close to the realities that prevailed. This would be a good opportunity to assess the effectiveness of such systems and processes, and whether they were helpful in providing boards with relevant data and information in discharging their duties towards their companies and shareholders.
As the saying goes, don’t let a crisis go to waste.
This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/how-your-board-dealing-brexit

What Companies Can Learn From the AOB Annual Report?

The Audit Oversight Board (AOB) recently issued its sixth annual report which covered its work and observations for 2015. While the report was predominantly aimed at the auditors of public interest entities (PIEs), it also contained observations and insights relevant to companies audited by the auditors concerned.
Hence, directors who are keen to enhance the quality of governance of their companies, particularly PIEs, should pay attention to the findings of the AOB.
In the context of the AOB, audit firms are divided into two groups: major audit firms and the rest. Why? The major audit firms consist of the larger firms that have more than 10 partners and audit close to 96% of public listed companies if measured by market capitalisation.
In addition to their reputation, their size and scale enables them to take larger and complex audit engagements. This is important for companies that have a significant presence in foreign markets. The other side of the coin is the 42 medium to small firms, which have only around 4% of the market share.
The skewed distribution of audit work creates different challenges for the firms. The larger firms have more work on their plate, thus stretching their resources in meeting deadlines. The type of clients they serve also requires them to deal with more complex accounting issues and make more challenging professional judgments.
As the smaller firms have a lesser amount of work, with a majority of them dealing with only one PIE client, their exposure to the complexities of auditing PIEs may be limited. If the enforcement actions taken by AOB are taken as an indicator, it appears that some firms in this category have issues in complying with auditing standards.
One of the key observations of the AOB for the major audit firms is the increase in the percentage of engagements requiring significant improvements, from around 10% in 2012 to around 18% in 2015. This means that close to one in five audit works of the major audit firms needed significant improvements.
Among the drivers of the findings are the inability of the firms to maintain consistent quality of work across all engagements, failure to consult their relevant experts in dealing with challenging matters and the need for further improvements in their systems to monitor work quality.
For other firms, while the percentage of engagements requiring significant improvements had improved from 80% in 2012 to 45% in 2015, the percentage of work in this category remained unsatisfactory. If the findings on this category of firms are analysed further, they would have more structural challenges compared to their larger cousins.
For example, the AOB highlighted gaps in the ways their partners’ performances are assessed, where quality is not being given adequate weightage, hence not providing enough incentive for them to ensure quality work is performed.
Other gaps identified include independence and ethical issues, failures to comply with the new client acceptance process properly and inadequate training, as well as the extent of involvement of partners in audit engagements.
Like prior years, there were common deficiencies in the audit work, which were noted across all the firms. They were in the areas of revenue recognition, asset impairment, group audit, sampling and reliability of information provided by management or experts.
Notwithstanding the remediation efforts made by the firms in response to the AOB’s findings in prior years, the effectiveness of those efforts seems to be questionable.
What do these findings mean to the board of companies audited by those auditors? There are a number of issues that the company boards need to give their attention to.
First, boards need to understand the strengths and weaknesses of the firms which they engage. What are the views of the leadership of those firms with regard to audit quality and what are their efforts to ensure the assurance provided to the board every year is reliable?
Given the findings of the AOB, boards are entitled to ask whether there are adverse findings against them and what they have done to rectify those shortcomings. While audit firms may play down the findings of the AOB, that view alone is already a red flag about the attitude of the firms regarding audit quality.
The second issue is about ensuring the firms have enough experienced staff, other than the partners, to deal with specific industry issues or complexities of the companies audited. While the partners are responsible for the whole audit, most of the work would be performed by more junior staff.
Questions around the efforts of partners in supervising the audit, and the experience and expertise of senior staff assigned to the audit engagement would provide ideas about whether the firms could handle the audit risks of the engagement.
Workload and tight deadlines are the third element which could influence the quality of an audit. Boards may also want to ask about resource allocations for their audit work and whether the firms are also committed to other large clients in the same period.
The AOB annual report provides good insights about the state of affairs of the auditing industry and possible shortcomings that could pose potential risks to the level of assurance provided to boards and shareholders. Those boards which are responsive to those findings would certainly be able to have better assurance and quality of work from their auditors.
This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/what-audit-firms-can-learn-aob-annual-report

Reacting To Red Flags, The Enron Experience — Lessons For Boardrooms

Andrew Fastow was ashamed with what he did when he was with Enron Corp. The former CFO of this company which fell from fame spectacularly in early 2000 admitted that he was guilty and felt sorry for all those people who suffered losses.
He was in Kuala Lumpur to share some of his experiences which could be good lessons for those in boardrooms to learn from. I conducted a fishbowl session with the former Enron CFO recently.

When Enron was growing, it required a lot of financing. The shareholders preferred not to inject new capital. Fastow used structured finance to allow Enron to borrow money using special-purpose vehicles (SPVs) resulting in the liabilities not recognised on the balance sheet of Enron.
It made its financials looked sound, cost of capital reduced and the shareholders were relieved from being required to inject capital. For this he was awarded the CFO of the year by an influential financial magazine in the US. The same conducts landed him in prison!
Was the board of directors ignorant of what had happened? No, according to Fastow. The board was supplied with information that reconciled Enron’s internal credit scoring, which was assessed as closer to junk status, to the market scoring where it was rated as an investment grade.
How did the board react? Instead of being worried about the misalignment in the assessment of Enron’s risks by the banks, he was praised by one of the board members as a brilliant CFO.
Everyone’s focus at that time was whether the transactions complied with the rules. This, according to Fastow, was the main factor which provided everyone with comfort that everything was fine.
What about independent professionals such as legal counsels and auditors? When their views were sought, they were not just required to provide opinions on whether rules were complied with or not. If they felt that there were no compliances, they were expected to provide ideas and ways so that compliance was achieved.
One of the reasons why Fastow was hired by Enron was for his talent in unlocking the value of Enron’s assets. Through structured finance and fair value accounting, the future values of those assets could be booked, enhancing the value of Enron’s shares.
Fair value accounting relies on the availability of market prices. In their absence, prices of similar assets could be used. When there is no such price, complex valuation models would be used instead.
On top of the issue of market price, fair value accounting also requires future stream of cashflows generated by those assets to be estimated. They are then capitalised at certain rates which reflect the risks carried by the assets, to arrive at their fair values. The exercise relies heavily on assumptions and estimates with its results subjected to a wide range of risks.
While those rules appeared complex, Enron capitalised them to its benefits. In fact, the more complicated the rules, the more they were seen as opportunities by Enron. The complexities made the transactions and valuations more opaque. Again, the focus then was whether all those rules were complied with!
Although two senior executives of Enron were sent to prison, Enron-like cases keep on appearing including during the recent global financial crisis. The scary thing is the market appears to tolerate a certain level of envelope pushing until certain events occur when they would then cry for blood.
At this point, compliance with rules would not be adequate and people should be asking whether things are right instead.
Enron had a very prominent board. Why didn’t they react with horror when they knew what was wrong about their financial standing?
There could be a number of factors behind this. Enron was the darling of the market and it provided good financial returns, at least before it collapsed. Everyone was chasing the money and nobody was concerned as long as the rules “were followed”.
Instead of pausing and asking the question “are we doing the right thing”, the board decided to continue to dance to the music liked by the market.
The board also had the comfort of independent professionals providing opinions that every rule was complied with. While what happened to Enron was a catastrophe, how many of the present members of the board would sign off a deal based on the comfort that it is in compliance with all relevant rules?
As boards tend to achieve consensus in making decision, such culture would deter people who have opposing views from staying the course.
Fastow believes that adopting the 10th man rule is the way forward. Here, someone would play the role of a devil’s advocate and keep on opposing the views of the board until it is clear that the views are premised on sound judgment.
So, what would be your reaction in the next board meeting when, in supporting their proposals, management comfortably explains that all the rules are complied with?
This article was published in The Malaysian Reserve under the column Boardroom View http://themalaysianreserve.com/new/story/reacting-red-flags-enron-experience-—-lessons-boardrooms

Can Shareholders Pose Risks to Their Own Investments?

A CONVERSATION with a friend who used to be a senior executive for a global company based in the US triggered this question. According to him the company he was serving was doing the right thing and managed to achieve double-digit growth for many years.
Then the shareholders were exerting pressure on the board to maintain this kind of growth forever. Although the board knew that was highly improbable as that would require the company to step away from its strategy and business model, they hired a new CEO who was supposed to be great at sales, with the expectation that the new CEO could expand the business further, generate higher revenue and continue growing the company at a high pace.
Although their business model was changed, they didn’t get what they wanted. The company eventually lost its leading position in the industry it once controlled and the new CEO was asked to move on.
While boards are stewards of companies on behalf of their shareholders and are responsible for putting in place management teams that are supposed to develop and implement business strategies which would provide good returns to shareholders, the dynamics between shareholders, boards and management could influence the risk factors and sustainability of companies.
One might wonder how shareholders could pose risk to their own investments. Shareholders are not homogenous and each shareholder has their own objectives and motives for investing in a particular company. These objectives would influence their interactions with their investee companies. This is where they could influence business directions, risk appetites and the conducts of those companies.

Retail investors would come and go. While they could generate excitement in terms of volume of shares traded, especially for companies with small market capitalisation, the size of their shareholdings may not be enough to influence the direction of the company as in most cases, they are not represented on the board.
Then we have individual shareholders who, individually or through their friendly parties, have significant ownership of the company. They could be the original promoters who started the company and are generally keen to see it remaining successful. Normally their shareholdings are significant enough to enable them to have seats on the board.
Their investment objectives would be about serving their own aspirations including retaining control. If their investments are funded through borrowings, they may have an expectation on the minimum amount of dividends from their investments to service the borrowings.
Another category of shareholders are those representing collective investment schemes, pension funds and fund managers who are investing on behalf of a larger pool of investors. By their nature, they are committed to providing a certain amount of returns, and depending on their investment mandates may also be significant enough to have board representations.
Generally, only shareholders with significant presence on the board would be able to control business directions, how much risk the company is willing to take, dividend policy and the quality of corporate governance. They would pose risks if, through their representatives, they exert pressure on the board to venture into an industry in which the company has no expertise, acquire assets at inflated prices, enter into related- party transactions without proper due diligence or maintain dividend policies as such that free cashflows dry up and there is not much left for the company to invest for future business expansion or contingencies, among others.
How would such risks be mitigated? 
The first line of defence is for all the directors to remember that they are expected to act in the best interests of the company. Any decision has to be predicated on this expectation. This also applies to those representing major shareholders. The challenge for those belonging to this category is whether they can act independently and perform their legal role or succumb to the expectations of the shareholders who are represented by them.
Risks could also be mitigated if the corporate governance arrangements operate effectively. For example, in the case of acquisitions of assets, the independent directors should ensure proper due diligence is conducted and the valuation of the assets is determined, for example, by professional valuers.
Any related-party transaction has to be scrutinised in the same manner with other similar transactions. If any of these steps is committed, the independent directors should vote based on the facts and have the interests of the company as a whole in mind.
Management could also play their role in providing supporting facts in situations where the interests of shareholders would collide with the business viability of the company. In cases where unfavourable dividend policy is proposed, clear facts on how much capital is needed based on the agreed strategic plans and the consequences if the company is under capitalised must be presented before the board, so they can decide with their eyes open.
Hence, when the board considers the effectiveness of the risk management practices of the company under their care, the potential risks coming from their shareholders should not be discounted and have to be mitigated in ways similar to other risks.
This article was published in The Malaysian Reserve in the column Boardroom View http://themalaysianreserve.com/new/story/can-shareholders-pose-risks-their-own-investments