Role of Chartered Accountants in capital markets

Capital markets are where companies which need long term finance, can meet investors who have finance to offer. This finance may be equity finance involving shares, or debt finance in which case companies can choose from a wide range of loans and debt securities. Capital markets are also where investors buy and sell securities of companies and the government. Their trading decisions reflect information on company performance provided by financial statements and financial analyses, dividend announcements by companies, market expectations - on the future levels of interest rates, inflation and investment decisions made by companies. Why are capital markets? These markets facilitate efficient allocation of capital across industries, and by extension, society as a whole. Also wealth is generated for savers-cum-investors by directing their savings to most efficient uses of capital and labour in companies seeking finance, on a long term basis. Functions of a capital market: Firstly, such markets are the place where long term funds can be raised by companies from those with funds to invest - such as financial institutions and private investors. In fulfilling this function, they are primary markets for new issues of equity and debt. Secondly, capital markets allow investors to sell their shares and bonds, or buy new ones to change composition of their portfolios. Here, capital markets act as secondary markets. The secondary market plays a key role in corporate finance, because by facilitating the buying and selling, it increases their liquidity and hence their value (by reducing risks). Investors would pay less for a security that would be difficult to sell at a later date. The secondary market is also a source of pricing information for the primary market and so helps to increase the efficiency with which the primary market allocates new funds to their best use. Determinants of efficiency: An efficient market needs operational efficiency, allocational efficiency and pricing efficiency. Operational efficiency means that transaction costs should be low and sales are executed quickly. Pricing efficiency means that share prices fully and fairly reflect all relevant information and so are fair prices. Allocational efficiency means that capital markets allocate funds to their most productive use by companies through cash generation requirements. Investment decisions: A number of issues and matters, as noted below, are important for making sound investment decisions. These are: A company demands capital when it has projects which can generate cash flow from operations and make a return on the capital, higher than its cost of capital; A saver offers his savings as investment when he considers he will receive a return higher than the riskfree rate from the sharesecurity; A proper regulatory environment is required to ensure that market is not misled about the potential of a projects of company, and all valueprice sensitive information is rapidly made available to market; Insider dealing is prohibited; Public announcements and regulatory submissions are required; Sound and proper persons' test for companies, auditors, regulators and market participants are enforced. Management and directors of companies are required to pass stringent sound and proper person tests. And these processes are continuous. Value creation and addition: Value is different than price; value is intrinsic, meaning within; value can be created by a company by enhancing surplus cash generation (reduce costs or enhance revenue), by reducing risks, by reducing pay-back period and other things that are determinants of value. Value may be added by undertaking projects which generates surplus cash at a rate higher than cost of capital employed. Value is destroyed when an investment has an internal rate of return (IRR) below the cost of capital employed; There are zero-sum games, like speculative betting, or gambling. Value of shares: Value of a share is discounted net present value of all cash flow from owning that share; The discounting rate is the appropriate cost of capital; Dividend valuation approach (DVA) relies on the equivalence of the market price of a stock, P0, with the present value of the dividends (or cash flows) expected from the stock. Valuation model: The discount rate in finding the present value is considered to be the cost of equity capital. Cost of equity capital = risk free rate +beta (market rate risk free rate) Re = Rf + (Rm - Rf) A firm's beta is correlationship of its price to market price movements. Value creation strategies: Value creating strategies, as noted below, can be applied in practice: Net operating profit after tax can be increased by eliminating unnecessary costs. Undertaking projects which generate returns in excess of the company's cost of capital, can be achieved by using net present value (NPV) and internal rate of return (IRR) as investment appraisal methods; A company's cost of capital can be reduced by the sensible use of debt; and the amount of invested capital can be reduced by disposing of unwanted assets and by returning unwanted cash to shareholders via a share repurchase scheme. Price of Finance: Price in a capital market, like any other market, is determined by supply and demand. Demand in this context in a normal capital market means demand for fundsfinance from companies or issuers of securities. Secondary market demand also affects prices. Supply in this context means supply of savings from investors in long term investments, mostly directed through structured savings arrangements such as pensions and insurance arrangements. Investment Principles for Savers: The first principle of investment is never loose your savings. So, one invests in risk-free capital, such as in Government bonds or securities, when seeking risk-free investments like when in pension age. Depending on risk profile, investors then add risk to investment profile and seek enhanced return to match the price of risks. The second principle of investment advice is always get paid back. Pay-back period, priceearnings ratios, interest cover, dividend cover etc., are all different ways for an investor to determine how long it would take to get paid back. Risk enhances with time, and longer the pay-back period, lower is the desirability of the investment. Chartered Accountants: Qualified Chartered Accounts have been playing a tremendous role in enhancement of governance, trust, efficiency and transparency in a capital market. Chartered Accountants with their ethics, integrity, and professionalism can provide the foundation of the basics of efficiency in the capital markets through assisting operational, pricing and allocation efficiency. Integrity, Ethics, Independence and Skills: In a typical capital market scenario, intermediaries, investors, issuers, corporate and regulatory authorities rely on ethics, integrity, independence and skills of the chartered accountants in discharging their respective obligations to the investors. The entire field of financial services relies heavily on trust of the work of Chartered Accountants. Roles: Chartered Accountants play the following roles, among others, in the capital markets: As an auditor to the company tapping the capital markets; Emerging practice role; As an advisor to the company tapping the capital markets; As a regulator working for Securities and Exchange Commission (SEC) or stock exchanges; As an entrepreneurial role - basically that of an intermediary; As an investment banker; In the initial public offering (IPO) process; As in other emerging roles. Auditor role: This role includes, among others, the following: Providing professional opinion on completeness, accuracy, compliance, and presentation and discharging the role of independent auditor depending on the situation, or; Ethics, and integrity of the professional is the key, as also the professionalism, independence in opinion; Providing the basis of trust in evaluation of transactions in financial markets. Auditors by their independent external and internal audit provide assurance on the quality and quantity of risk in the financials of the company, thus, reducing the risk premium required in investing in the company. The London Stock Exchange still requires all their listed companies' financial statements to be audited by Chartered Accountants, whilst the rest could be audited by any registered Auditors. Advisory role: The advisory role has evolved from being an advisor on tax and related matters to positioning the company amongst the knowledgeable investors, advising the company on the value chain which they need to pursue, and continued feedback on the key acts which the company must do to sustain its valuation, attract quality investors interest etc. Keeping in view the complications and stiff pulls and pressures of burgeoning capital markets, the skills and expertise of trained Chartered Accountants are highly relied upon by the financial services sector, intermediaries, investors, issuers, corporate and SEC, Dhaka Stock Exchange (DSE) and Chittagong Stock Exchange (CSE). And now, more opportunities await the professionals in this area. Emerging practice role: The whole approach towards risk management controls have changed. Managements are increasingly providing a better budget for risk management and Chartered Accountants play an important role as the Chief Risk Officers, or Chiefs of Internal Control; Knowledge of accounts, accounting, finance, financial analysis and law pertaining to issues of securities with regards to provisions of the Companies Act, Securities Exchange Commission Act etc, have now assumed a greater importance than before; In addition, knowledge of the client or the issuers' business helps in profiling and positioning of the business to the outside world at large. This is the key ingredient to any fund-raising plan. Certifying: Accountants play a key role in advising oncertifying a number of critical issues. These include, among others, the following: 1. Compliance with the corporate governance; 2. Promoter contribution in a project; 3. Amount deployedspent on project. Furthermore, in matters of requirements to capitalize with the expansion in the role, approach and accountability, there is a tremendous responsibility cast on the Chartered Accountants to play their role effectively and stay ahead in the competition. Again, Chartered Accountants by their ethics, integrity and independent professional position provide assurance on quality and quantity of risks in those opinions and financials. Role as a regulator: Chartered Accountants can work as a regulator either for stock exchanges or for SEC. They also work for Bangladesh Bank and Government. As a regulator, Chartered Accountants can be skillfully employed in policymaking, monitoring review, maintaining surveillance and carrying out investigation; Members of the Institute of Chartered Accountants of Bangladesh (ICAB) have been acting for the SEC and are also on the boards of the DSE and the CSE; ICAB members have been co opted in the investigation committee, set up by the Government recently to investigate the affairs of the capital markets; There is increased realization among market participants that having a Chartered Accountant on board pays: It pays to pay a Chartered Accountant, or keep his company as such. As an entrepreneurial role - intermediary: New investment banking firms, broking entities and the improving regulatory environment have encouraged Chartered Accountants to become entrepreneurs by themselves. With the better understanding of the financial products, Chartered Accountants have become an effective entrepreneurs in distribution, wealth management etc. Investment Banker: As an investment Banker, a Chartered Accountant also helps in formulating financial strategy to successfully tap the capitall markets and ensure success for the fund raising plan of companies. Putting together an efficient capital structure, creating financial model, profiling business promoters and management and advising on valuation are the other key ingredients for making successful entries to the capital market. Contribution to Efficiency of Capital Markets: No stock market anywhere in the world is a perfect market. However, companies and investors rather need capital markets to be efficient and to offer fair prices and good regulatory environment so they can make reasoned investment and financing decisions and executions. Chartered Accountants with their integrity first and their professionalism in the second, provide the basis building-blocks for the trust that is required for the efficiency in the capital markets. IPO Process Roles: The independent accountant's role in the initial public offering (IPO) process includes auditing the financial statements, restating them in compliance with SEC requirements, and resolving accounting issues. Increasing emphasis is being placed on the scope of "comfort letters" which a company's auditor provides to the underwriters and the company's board as part of their due diligence. Commentary on accounting policies and problems, improper revenue recognition, avoiding changes merely for the purpose of inflating profits are few of the areas, where the accountants insight are sought. Accountants can also leverage their experience during the planning phase to help ensure that the records with the office of the Registrar of Joint Stock Companies (RJSC) are in order before the IP0 process. Other emerging roles: Playing the roles of financial analysts, media experts covering the capital markets, investment advisors, marketing of financial services etc., are some of the emerging roles for the young Chartered Accountants to deploy their skills effectively. Self Assessment: There are scopes for improvement in what the Chartered Accountants do. They are all products of their environment and the environment affects them. They need to do critical self-examination as to how well they do what they do. Are the Chartered Accountants united? Do they have a proper voice? Are they delivering up to their full potential? All these questions are relevant here. All the works of the Chartered Accountants alone could not have prevented the stock market going up and then coming down; that is what markets do. Audit is the principle monopoly activity of this body of professionals. This is an edited version of a keynote presentation made by Ferdous Ahmed Khan, BSC, MBA and FCA to a Continuing Profession Development (CPD) Seminar held in Dhaka on March 21, 2011 under the sponsorship of the Institute of Chartered Accountants of Bangladesh (ICAB)