Breaking the Business-auditor Nexus Is Key to Financial Clean-up
On 11th June, the ministry of corporate affairs (MCA) moved the national company law tribunal (NCLT) with a 214-page petition to bar Deloitte Haskins & Sells (Deloitte), statutory auditors of IL&FS Financial Services (IFIN) and BSR Associates (a part of the KPMG network in India), for five years for colluding with management to bury serious issues of round-tripping money and ever-greening loans by buying the auditors’ silence through consulting assignments and worse. The complaint is against Deloitte, its chief executive Udayan Sen, partner Kalpesh Mehta and BSR’s partner Sampath Ganesh. 
 
A whistle-blower’s letter, first published in Moneylife on 10th April, was the basis of a quick investigation by the Serious Frauds Investigation Office (SFIO) leading to this petition being filed in record time.
 
The commendable speed with which SFIO has conducted its investigations and followed them up with filing of charge-sheets is a refreshing development that has been missing for the past 30 years, including for major security scams of 1992 (Harshad Mehta) and 2000 (Ketan Parekh).
 
Hopefully, it will lead to far better outcomes than in the past, if the judiciary cooperates and does not allow lawyers to game the system with endless adjournments. 
 
SFIO has, correctly, targeted statutory auditors first. While it is true that the Reserve Bank of India (RBI), lenders (including mutual funds—MFs), rating agencies and others have failed in their responsibilities, statutory auditors are the first watchdogs that failed to bark. The others, to an extent, can hide behind audit reports being a true reflection of the organisation’s finances, to justify their own complicity. 
 
When Ramalinga Raju of Satyam wrote his famous confession in 2009, he also threw the marquee audit firm, Price Waterhouse & Company (PWC) under the bus. But, although PWC was a controversial and repeat offender, the Securities and Exchange Board of India (SEBI), under two chairmen, allowed the investigation to drag on for nine years. It handed a two-year ban and disgorgement order only in June 2018. This order also did not affect its on-going audits. Is it any surprise that Deloitte thought nothing of colluding with the failed IL&FS group until it led to a systemic panic?
 
But this is not the only instance. Quick and decisive action by the MCA is throwing up a lot more dirt, probably because auditors realise that the government is serious this time. I am just putting together revelations in the past few weeks alone, which show how the rotten, business-auditor nexus has attained grotesque proportions and inflicted a massive cost on the financial system. Here are a few examples.
 
1. PWC vs Reliance: On 11th June, the shares of Reliance Capital and Reliance Home Finance, both from the beleaguered Anil Dhirubhai Ambani group (ADAG), which has already been exposed for various collusive deals, collapsed on the news that PWC had refused to sign the accounts and resigned with immediate effect. 
 
The ADAG companies reacted with the usual bluster and threatened legal action against the auditor. PWC’s decision to walk out happened after the REDD exposure about the ‘box system’ used by DHFL and Reliance Capital to circumvent rules and well after the MF industry’s controversial lending to these groups had caused panic among investors. 
 
Reliance has said it will finalise its accounts with the other auditor, Pathak HD & Associates, whose term remains valid. So far, all regulators are silent, while NAVs (net asset values) of some debt schemes went into a vertical fall. Now, in a sensational new development, PWC has written to MCA that it has been threatened and intimidated by Reliance Capital.
 
2. Infibeam Avenues vs SRBC & Co LLP:  On 11th June, while ADAG was hogging the headlines, Infibeam Avenues announced that its decision, to ‘terminate’ SRBC & Co LLP, its joint statutory auditor, was approved by MCA. The audit firm, which is part of the Ernst & Young (E&Y) group, was accused of having leaked unpublished price-sensitive information and had earlier denied the charges. It is not clear if this will lead to further regulatory action, but the allegation reveals another venal side of the business-auditor nexus. Every major corporate development indicates information leakage as evident from stock price movements. Moneylife regulars would have read our many exposés of this problem. 
 
3. Eros International Media Ltd and Hindenburg Research: The case erupted on 6th June after rating agency CARE revised its rating on the company’s long-term bank facilities from BBB- to D, and on its short-term bank facilities from A3 to D, or default.

The agency, apparently, woke up just as Hindenburg Research, a US-based forensic financial research firm, and an admitted short-seller of the stock in the international markets, was getting ready to put out an explosive research report. 
 
Its deep audit of this New York-listed Indian company exposed how the audit committee of Eros as well as its statutory auditors have ‘failed to raise the red flags’, despite enough holes in the company's functioning. It also says that Eros’s “bankers seemed more interested in generating fees through debt & equity offerings than in performing credible underwriting” and that the “complex international structure made it too challenging for regulators to enforce.” The Indian auditor of Eros International is Chaturvedi & Shah, which has an association with the Reliance group since the 1980s. Mukesh Ambani controls a 5% stake in Eros.
 
Eros’s advances had surged 207% and receivables shot up 66% in 2017-18. When Hindenburg Research examined Eros’s claim about not being able to collect trade receivables (largely unsecured), it found that these receivables, largely, did not exist. The forensic investigation also went deep into its subsidiary companies to expose how it used a web of shell companies to round-trip money to promoters.  The auditors clearly looked the other way, despite years of warning signs.
 
“We think Eros’s collapse is an egregious failure of its auditors, Grant Thornton, to apply even basic scrutiny to the company’s financial condition,” it says in a scathing indictment. This is a stunning because Grant Thornton did a terrific forensic audit for IFIN (of the IL&FS) group in what is called Project Icarus. Its findings have helped SFIO in that investigation. So far, no regulator has reacted to this.
 
The Hindenburg investigation has, finally, proved long-standing rumours that Indian companies have been using small and unknown auditors to sign off on subsidiaries and shell companies that were used to route and round-trip money for promoters. Hindenburg Research exposed, with photographs, how Eros Television India Pvt Ltd’s audit firm was housed in a slum rehabilitation building with barely one table space. 
 
The report concludes, “Eros's unravelling is like the obvious ending to a cliché movie.” I would say that Eros is just one of the scenes in this movie; the dirt that has spilled out in June alone suggests that it is the audit industry’s credibility that is unravelling even more rapidly. 
 
The question then is: Where are we headed from here? Remember, RBI has already barred SR Batliboi & Company from handling audits of commercial banks for one year. This seems like a slap on the wrist, but actually causes a major upheaval for the firm, since clients forced to move on for lapses in statutory audit may not, necessarily, return after a year.  
 
With PWC, Deloitte, Grant Thornton, SR Batliboi (of the Ernst & Young group) and BSR (part of the KPMG group) under a cloud, all the big global names of the audit world have been hauled up for serious lapses. It has already triggered media reports projecting a gloom & doom scenario for India, if all major audit firms face punitive action. 
 
This is a fake fear-scenario propagated by the big four and their powerful lobbying machinery working through mainstream media. Every major upheaval creates an opportunity for growth. Remember, the Deloitte whistle-blower was an insider. Such People need an opportunity to become independent and grow. 
 
In 1992, several lawyers told me how their business quadrupled after the central bureau of investigation (CBI) and banks went on a spree of filing litigation, because the government failed to separate civil issues from criminal fraud and settle the former out of court. Today, many of them are considered marquee law firms. 
 
Companies will be governed dramatically better if managements fear statutory auditors. The government failed to send a strong signal to multinational audit firms after the Satyam scandal. It would have ensured a clean-up long before our bad loans ballooned to Rs10 lakh crore and several major companies went bust. 
 
The timing is just right again because several disparate events have converged simultaneously. Fortunately, MCA has acted firmly, decisively and quickly with IFIN. Let’s hope the momentum continues.
 
(Editor's note: this column has been updated with a correction in rating information).
 
 
Comments
Saatvik Atri
2 years ago
Very informative article . Thanks for these insights.
Sajjan Isaac
2 years ago
(https://balablogsdotcom.wordpress.com/2019/06/15/warren-buffett-on-audit-committee/)
WARREN BUFFETT ON THE CHALLENGE OF THE AUDIT COMMITTEE

Often called the “Oracle of Omaha,” Warren Buffett, the largest shareholder and CEO of Berkshire Hathaway, is well known for his adherence to the value investing philosophy, his conservatism when it comes to issues of governance and accounting, and for his personal frugality, despite his immense wealth. On the subject of a board’s audit committee, he writes,Buffett, annual letter to Berkshire Hathaway shareholders (2002).

Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect. Reforms that ignore this reality and that instead focus on the structure and charter of the audit committee will accomplish little.

As we’ve discussed, far too many managers have fudged their company’s numbers in recent years, using both accounting and operational techniques that are typically legal but that nevertheless materially mislead investors. Frequently, auditors knew about these deceptions. Too often, however, they remained silent. The key job of the audit committee is simply to get the auditors to divulge what they know.

To do this job, the committee must make sure that the auditors worry more about misleading its members than about offending management. In recent years, auditors have not felt that way. They have instead generally viewed the CEO, rather than the shareholders or directors, as their client. That has been a natural result of day-to-day working relationships and also of the auditors’ understanding that, no matter what the book says, the CEO and CFO pay their fees and determine whether they are retained for both auditing and other work. The rules that have been recently instituted won’t materially change this reality. What will break this cozy relationship is audit committees unequivocally putting auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.

In my opinion, audit committees can accomplish this goal by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:

If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.
If the auditor were an investor, would he have received—in plain English—the information essential to his understanding the company’s financial performance during the reporting period?
Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?
Is the auditor aware of any actions—either accounting or operational—that have had the purpose and effect of moving revenues or expenses from one reporting period to another?
If the audit committee asks these questions, its composition—the focus of most reforms—is of minor importance. In addition, the procedure will save time and expense. When auditors are put on the spot, they will do their duty. If they are not put on the spot… well, we have seen the results of that.

(from https://saylordotorg.github.io/text_corporate-governance/s08-02-warren-buffett-on-the-challeng.html )
R P SHIVKUMAR
2 years ago
excellent atricle , There is a lot of scope for disclosure systems in companies and better quality auditors. Also the press has to report on in more detail about the collapse of mid cap companies like zicom, rolta mcleod russell in detail and let investors know more about their investments and not just the top few
Sadanand Patwardhan
2 years ago
Regulator: Auditor, you should maintain strict neutrality, independence of judgment, due diligence to bring out accurate & material picture of the business and it's compliance (or not) with statutory obligations. Any deviations must be reported without favour or fear.

Auditor: Yes sir, err.. you are right; but how can we bite that hands that feed us. We will be out of business.

ICAI is merely sitting on it's haunches and has let rot set in.

Solution?
Audit the auditors, regulate the regulators, watch the watch dogs.
But then who will monitor these 2nd order creatures.
Rot is systemic. More bureaucracy will only mean more painful burden on the citizenry.
Aditya G
Replied to Sadanand Patwardhan comment 2 years ago
Absolutely. Honestly, there's no solution for auditors. I can only feel their plight.

They're in a catch-22 situation. I've known a lot of CAs who have dropped out of practice because it's:

a) not lucrative enough
b) the reputational risk is just too high
c) Monotony (well, this is nearly universal everywhere...but nowhere is it more pronounced in auditing profession...)

The ICAI has royally screwed up the profession. An entry level IT techie out of engineering college earns more than a CA. So, I'm not sure what the exact problem is. It's definitely an ethics problem, but not anymore important than feeding your family. The economic and professional incentives are skewed against auditors IMHO. This has to change.
vj
2 years ago
Similar investigation/action is also needed in case of business-corporate advocates nexus...all professionals who are discharging statutory duties must bear obligations and accountability in equal proportions so that they act in public interest and not only in the interest of their clients and employers. Otherwise they are always tempted to abuse the monopoly given to them by the statute.
vj
Replied to vj comment 2 years ago
In short such professionals be treated as Public Servant and be regulated accordingly.
Shankar g
2 years ago
Not only barring by judiciary and Govt is enough but should also make those BIG 4 accountable & recover the money lost by the individuals/ companies/ Banks & Govt . ex-chequer
Mohan Krishnan
2 years ago
Especially in the case of IL&FS where even Armed Forces Pension Funds were not spared (Financial Pulwama attack), all the related entities should be booked under Prevention of Terrorism Act.
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