In the Indian context, the record of the audit in situations where it ought to have shown its utility, if not the vitality, can be assessed by looking at the data and examples coming out of the IBC (Insolvency and Bankruptcy Code) process.
Though any audit report is addressed only to the members of a company, bankers place much reliance on it for their lending decisions. Equally, the credit rating agencies, whose work is, in turn, relied on by the bankers and other lenders, bank on the audit report and do little independent diligence on the potential credit risks.
Some data at a headline level till March 2023 indicates that the financial creditors at an overall level recovered about 32% of the loans given to companies that became bankrupt.
This, again, is largely, if not solely, banks that lent against the full security of the fixed and current assets. The others, like the debenture-holders or fixed deposit (FD) investors except in very few cases, had to accept a full default.
If a fully secured lender gets 32 paise to a rupee in insolvency distribution, the question arises whether the books inflated the value of the assets or showed fictional ones.
If the audit process was, indeed, robust, the companies could not have borrowed to the extent they did, due to inadequate collaterals on the books, and thereby the loss to the lenders would have been lower.
This analysis may sound a little distant and theoretical and some readers may frown at this for too much generalisation.
To double down to a slightly more precise examination of some of the cases that went through the IBC process, the starting point can be the dozen famous cases with which the IBC process made its debut.
In 2017, the Reserve Bank of India (RBI) cracked the whip on the reluctant bankers and forced them to refer their major defaulters to the IBC process.
These companies came to be referred to by the dubious moniker, 'dirty dozen' an insult to the movie of the same title released sometime in the 1960s, depicting the enthralling action around the Normandy landings during WWII!
The chart alongside, while not pretending to be a substitute for the regular audited accounts of these entities, gives a glimpse of the financial snapshot of these 12 entities for a quick and ready understanding.
A more detailed depiction of the financial condition of these companies would have done greater justice to the inferences proposed to be drawn out of this.
The two relevant columns to focus on would be the debt/ equity number and the interest coverage ratio.
Even someone not too familiar with the nuances of corporate finance will be aghast that banks were so naïve to lend to companies in such financial distress.
Why did not banks which, typically, lend only with sufficient security cover of assets, pull the plug at an earlier stage when the ratios had quite deteriorated? And failed to insist on the promoters to fund additional equity?
How did banks allow themselves to fund Alok Industries, which had a negative net worth of Rs290 crore and a negative earnings before interest, taxes, depreciation, and amortisation (EBIDTA), an amount of over Rs22,000 crore?
Unfortunately, a handy table like what is available in Alok Industries is missing.
It may be shocking to know that this account became a non-performing asset (NPA) in 2013, but was restructured by banks, and further monies were lent, quite likely on the back of the false accounts, and finally taken to IBC in 2017.
The forensic audit done at the instance of banks revealed serious frauds committed during the period 2005 to 2012.
Audit failure stands proved based on the findings of the forensic audit and the ongoing CBI (central bureau of investigation) investigation.
Agencies like the Institute of Charteres Accounts of India (ICAI) ought to have studied all these major cases and brought out a report showing how much the audit was responsible for the fiasco that led to so much public wealth being lost.
There is another set of data of companies that were liquidated in the IBC process.
The liquidation value is an astonishing 5.6% of the admitted claims of the banks.
The table does not even feature operational creditors which may well be a significant number.
And these are not distressed agriculturists in Vidarbha who lost all their belongings and cannot pay the lenders but leading corporates supposed to be running a transparent business duly audited, and supervised by a board.
How can the liquidation value be a miniscule 5.6% when loans are, typically, fully secured in the Indian banking context?
It is inconceivable to witness such an outcome except where the accounting was entirely dodgy, the audit was a farce, and overlooked the inflated value of the assets in the books which the banks lent against.
The company-specific data is shown in the graph here.
In fact, the average of 5.6% has been boosted by a couple of cases which recouped a little less than 20% of the loan outstanding.
The inference of the failure of the audit to check the artificial inflation in the value of the assets shown in the books is inescapable when the realisable value of a business is so abysmally low, when the assets are sold and realised.
Only a casual and a conniving audit can lead to such results. The oft-repeated charge that the banks did poor underwriting is only partly correct. To a large extent, they were misled by the doctored accounts which the auditors failed to reject.
No discussion on audit failure can be complete without a mention of the biggest loot of the investors till date, by the Wadhawan brothers, Kapil and Dheeraj!
When Deloitte Haskins & Sells LLP (Deloitte/DHS) along with the joint auditor Chaturvedi and Shah issued the limited review report for the first-half year accounts for the period ended 30 September 2018, Dewan Housing Finance Ltd (DHFL) had borrowings of Rs1.1 lakh crore. It comprised of debentures, both redeemable and perpetual, of Rs51,732 crore, public deposits of Rs10,457 crore and bank loans of Rs45,458 crore.
DHFL had a unique borrowing pattern that relied on the market more than banks.
On a comparative basis, the total as per the audited accounts of 31 March 2018 was Rs70,214 crore.
It had managed to borrow additionally Rs37,433 crore in just a six-month period and a substantial part of it was directly from the market, principally unsecured debentures.
This extent of growth in borrowing and lending by a housing finance company (HFC) that, typically, lends an average ticket size of about Rs25 lakh to Rs50 lakh, adding in the process lakhs of new borrowers, should have kindled suspicion. All in 180 days' time!
There is little corroborative evidence of any major pick-up in the housing market during that period and quite possibly no big credit expansion took place for the other HFCs.
These are easy and simple checks for any auditor to carry out in the present information age to get a decent grip of the overall business situation and understand the extent of divergence in a specific client's case.
Deloitte, which boarded DHFL as the joint auditor during that year and was involved in the conversion of the books from I-GAAP to Ind AS, should have paused in its tracks and smelt the fish rotting!
Being a new auditor places an extra onus on Deloitte to have assessed the client for potential misstatement in the financials and two quarters is a good long time to get to grips on the core aspect of lending, where all the diversion took place.
Caution and extra checking should have been the watchword since another Deloitte stellar audit client, Infrastructure Leasing & Financial Services (IL&FS), had just come apart in September 2018, taking the entire financial down with it.
Many of the debenture-holders had put in their money just a few months earlier when the fundraising was at a frenzy.
An offer of 10.5% to 12% coupon, based on the tenure, by a company boasting a strong (wrong!) balance sheet, stamped by a global audit firm, with all CRAs (credit rating agencies) rating it AAA, was something that should have created some suspicion at least in the minds of the investor, if not the two auditors!
And a good deal of the investments happened from corporates with surplus funds, private trusts managing provident fund and gratuity, and some of the public institutions like the Army and Navy fund.
This was the first instance of an NBFC (non-banking finance company) being subjected to the IBC process and the banks walked away with most of the resolution package and even they were given a raw deal of a paper exchange by the acquirers, Piramal group, that would mature over many years and earn 6.75%!
The loss to those holding the unsecured debenture was almost 95%.
It is a monstrous mistake that neither of the firms, who are as culpable as auditors in any other case of swindling by the management, was brought to book!
By August 2019, both the auditors resigned and managed to avoid putting their signature to the final accounts for FY18-19.
The half-yearly and the quarterly statements signed by them bore the caveat that it was not an audit!
While the auditors may seek escape on the ground of resignation, which seem to have passed muster with NFRA, which has charged only the new auditor that signed the annual accounts, there can be no moral exculpation of them for the egregious lapses that failed to detect the loot.
The fact that the auditors were unaware of what happened till the lid was blown off the scam by Cobrapost is indeed an indelible stain on not only the two firms for their collective incompetence but on the very system of audit that investors see as a check and a source of comfort.
KPMG checked the very same books of accounts and confirmed the swindle.
Clearly, the auditors had either no knowledge of the scale of the fraud or they believed it may be sorted out by the promoters sooner than later. They would not have anticipated the exposé by Cobrapost that set the cat among the pigeons.
Cobrapost's take on the auditors sums it up best!
It also raises a question on the role of DHFL auditors. Cobrapost says, "In the cases of the shell companies investigated, of DHFL and Wadhawan's own companies, auditors have consistently failed to bring serious irregularities in their audit reports, which are meant to ensure that the financial statements of companies are free from any irregular activities. The irregularities that seem to have been overlooked by auditors with surprising consistency uncover the possibility of collusion between multiple auditors and the companies in question."
Should the hope still linger in some readers that audit can be redeemed from the present mess, do await the next part, soon to follow!
Postscript
Is the fact of audit failures due to poor work quality and the news that the unfortunate death was caused by overwork on audit engagements, contradictory?
They actually do not, and, in fact, maybe more corroborative.
In bigger audit firms, especially the big-4, the audit is driven by the managers, who themselves may be quite inexperienced. They manage a team of freshly qualified CA or article clerks. The potential for harassment and insensitivity in handling people when inexperienced managers run the assignment is high.
The reason why the partners don't take a more active role in supervising the audits is that they are pushed to sell and market more work for the firm, increase the billing, and cultivate relationships with the top echelons of the companies, CEOs and promoters. Hence, spending time in the clubs, or golf courses is a desideratum!
How can any audit challenge the client or call out fraud if the audit partner or his boss is cosying up to the promoter in a bar?
This is the concluding part of a two-part series.
You may want to read Part-1…
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)
