Financial fraud can be classified into a few conventional models.
The one prevalent in the days when the stock market valuation was not the driving reason and when the tax rates were high was inflating the expenses and/or understating the sales.
The owners would sponge out the money by the above routes and accumulate it in safe havens and bring it back as equity investment in the same or a different business.
Globally, this method was followed by using transfer pricing to collect the money in tax havens. It was not considered a cardinal sin if the idea was only to avoid taxes.
But, not too rarely was this used to launder money outside the system.
There was—and still is—a large industry supporting this model. Despite the many safeguards like anti-money laundering initiatives, restrictions on banking secrecy or financial action task force (FATF) dictates, little has abated in this universe.
This pattern of siphoning out the money through under-invoicing and inflating the expense bills was not detrimental to the interest of the creditors unless the siphoning out was abnormal, leading to a collapse of the business itself.
To the extent the siphoning out was at a sustainable level, the cost of this practice was only lower tax collection and accumulation of black money, but with no detriment to the creditors and lenders.
The other plank is boosting the revenue and profits to play the market dynamics and using the high price to sell more shares and using the inflated books to raise more bank loans, by artificially showing higher inventory and receivables.
In India, in the post-liberalisation era, this became the favoured model. A long list of established and new companies have used this to raise funds from all possible sources, and finally, collapsed as well, with little to count as residual assets.
Many private equity (PE) funded cases including the most recent and the biggest, Think & Learn, alias BYJU, are said to have followed this playbook.
This model is highly detrimental as both, the investors in debt and equity, directly lose value.
Most insolvency cases have shown very dismal recovery rates because the debts were raised on the back of boosted and fictitious numbers in the books.
In other words, the manipulation of accounts is seldom by using some sophisticated technology tools, or by twisting or misinterpreting accounting standards or something that necessitates an Isaac Newton to audit and detect!
In this regard, the latest circular of the national financial reporting authority (NFRA), holding that the absence of an auditing standard that enabled the auditor of the holding company to check the audit papers of the ones auditing the component entities as the villain for letting frauds go undetected, sounds quite farfetched and not in any way close to the reasons for the frauds mentioned in the circular.
The above cases fall into the category of outright fraud, like any Ponzi scheme of raising money from the public and diverting it through different structures.
In all the cases, the auditor of the entity could have easily checked the destination of the funds as in all the cases the regular banking channels were used to send the money out.
All the above cases involved circulating the money within the country with full traceability. Copies of bank statements and know-your-customer (KYC) documents could have easily been insisted on to check the end use of the funds.
If the auditor could not get a full picture despite trying hard, or was not given due cooperation, these cases should have been referred to the economic offences wing in each city.
Instead, the audit firms—mostly the Big 4—issued, quarter upon quarter, non-qualified reports, and finally ran away by resigning once the full picture was known, thanks to some whistle-blower!
The reasons cited as the cause for the fraud by NFRA are again missing the wood for the trees!
The frauds were simply diversion of funds and entirely traceable which has been done subsequently by some agency.
The Institute of Chartered Accountants of India (ICAI) has opposed this vigorously as being detrimental to the small auditors. NFRA has said that this rule will impact just a fraction of the audits of listed companies.
Neither side has provided any credible data, as is typically the case in most debates in the country!
While the rule that the auditor of the holding company should have access to the audit done at the component level is unarguable, the point that is highlighted here is that the audit failures in all the big frauds in the past over 20 years that one can recall from memory had little to do with this lacunae.
As observed in the introductory part, the frauds are carried out in a very simple and conventional way. Not just in India, but even in the more advanced economies. The frauds have little to do with the existence or otherwise of some particular accounting or auditing standards.
In 2017, one of the titans of the American stock market, General Electric, admitted to fudging its profits from the insurance business for many years and paid a fine of US$200mn (million) to the Securities and Exchange Commission (SEC), after restating its accounts. It was audited for well over a century by the same audit firm, KPMG!
The US system has all the possible checks and balances, the most advanced accounting standards, legal safeguards like the Sarbanes Oxley law, and the toughest security regulator in the world, to boot!
The fraud was just a simple misstatement in the books to show more profits.
The reason this is highlighted is to make the point that frauds happen despite the existence of more and more complex standards like US GAAP or IFRS, etc.
It is often the surfeit of these standards that gives scope for selecting some convenient escape route to which the auditor falls prey.
The failures in audits are almost invariably due to not checking the books carefully and intelligently. That has little to do with a mastery of the complicated standards and interpretations.
There are many conventional ways of locating the fraud of boosting the revenue which currently seems the most adopted method.
The latest to attest to this affirmation is the failure of EY’s audit in NMC Health.
What did EY fail in, as the auditor? Was the fraud done using the latest AI software or a very sophisticated technology tool?
Neither!
EY appears to have failed in the most technically challenging task of asking for the ‘general ledger’ (GL) of the company!
Not just for one year, but over seven-odd ones!
In the good old days of manual bookkeeping, there would be a fight among audit team members for first laying hands on the GL, as that would normally help easy identification of the aberrant items.
There appears to be no sophisticated ploy to cheat the auditor in this case.
The parts duly coloured will show why EY’s audit lacked any!
The discussion on why the present model of audit is the least convincing answer to ensure the reliability of the financial statements will continue.
(This is fifth part of a multi-part series)
You may want to previous articles in this series…
(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.)
