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Are Auditors doing their Task : DHFL Crisis & Satyam Scam or Banks Going Down

Why Auditors be not Punished for irregular reporting?

There is no room for leniency towards auditors who collude with managements to present an incorrect picture of a company’s financial health to its stakeholders. The importance of finances made public cannot be overstated, as these are relied upon by lenders, creditors and investors for making important business and investment decisions. So, if an auditor knowingly permits falsehoods to be spread, it is unforgivable and must attract severe punishment.

This said the profession is a very individual-centric one, quite like that of a medical practitioner or a lawyer. The way an audit is conducted and managed would largely be driven by the honesty and ethical code of the partner leading the assignment and his team. It is therefore possible for highly ethical, less ethical and unethical audit professionals to co-exist in a large firm, though governed by some overarching organisational principles and processes. In fact, it is not uncommon to find facts hitherto unknown being revealed when the team conducting a company’s audit, from the same firm, changes.

Then again, there are two extremes of the roles auditors can play. While at the one end, one must appreciate how much an auditor can be held accountable for, given that they can only evaluate whether entries are accurately made and that these are backed by proper documentation and corroborated by statements by banks and other third-parties, at the other, many chartered accountants are known to support their clients through creative accounting practices — including buying and selling entries from other companies to paint a prettier picture.

The approach should be to punish the errant, not the innocent. If the audit firm is punished and not the individual, the unethical professional could very well jump ship and go back to her / his old ways without any penance.

What’s more, blanket bans on top audit firms would cause unnecessary disruption and perhaps open the doors for even less ethical professionals to fill the void.

Such disruption and auditor shuffling is hardly warranted. Rather, a rotation of audit teams from a firm even within the auditor rotation cycle could be instituted to keep both audit tam members and managements on their toes. This along with strong deterrents against audit malpractices should do the trick.

DHFL is a non-banking financial company, also known as a shadow bank. This means it doesn’t have a banking licence or access to central bank liquidity, but is nevertheless involved in financial services – in this case, primarily giving loans to home buyers in India’s tier 2 and tier 3 cities.

In 2018, another major NBFC, IL&FS, went bust, causing alarm bells to ring throughout the industry. Banks became much more careful about lending money to NBFCs. But this led to a liquidity crunch, since there was limited access to credit. Many NBFCs rely on short-term borrowing to finance long-term lending, which puts them in a difficult spot when there is a liquidity crunch.

In September 2018, after the IL&FS crisis emerged, DHFL’s stock also took a hammering, by as much as 60%. Then, in January, Cobrapost claimed that the company’s promoters were involved in a Rs 31,000 crore scam to siphon off money. The company denied these claims and later said that an independent chartered accountant’s inquiry found them to be untrue.

Nevertheless, the combination of factors put DHFL in a difficult place, forcing the company to sell a number of its businesses to ensure it could pay back on debt. Regardless, on June 4, the company failed to pay about Rs 900 crore worth of interest, prompting ratings agencies to downgrade all of its commercial paper.

The company insists that this is only a temporary problem and has said that it will pay back the amount within the seven-day grace period. If it is able to do so, this will allay some fears about this being an “insolvency issue” – whether the company itself can survive. Instead, it will become just a “liquidity issue”, suggesting the company just needs more time to mobilise money.

DHFL has insisted that the underlying assets that it holds, a big chunk of which are house loans, are valuable and have a very low non-performing asset percentage. But those underlying assets are worth about Rs 1 lakh crore. As a consequence, if this is indeed a solvency issue, if the company’s survival itself is uncertain, it could be a huge blow to India’s financial markets. This will lead to further panic – and tighter liquidity – across the system.

If the company fails, that will affect all of those that have extended credit to the company. That includes about Rs 50,000 crore from banks, another Rs 30,000 crore from the Life Insurance Corporation, pension funds and more. In other words, this isn’t about just one company failing: it is a danger to the already-beleaguered banking system.

One sector has already been affected: mutual funds, which allow investors to put their money into a selection of stocks as picked by a fund manager. Indian regulations mean that once payments have missed their due date, ratings agencies have to move immediately to change the rating of the company, in this case move DHFL down to “D”. Subsequently, mutual fund companies have to immediately follow suit, and mark down all DHFL debt 75%.

That means that, if a mutual fund owns DHFL debt – even if it is not the bonds that the company was unable to pay in time – it has to be marked down 75%. UTI Mutual Fund, for example, which owns a large amount of DHFL paper has written down all of that debt completely, meaning it doesn’t expect to get anything back.

This may change if DHFL does indeed manage to pay the money back by Monday as promised. But regulations mean ratings agencies cannot immediately change the company’s grade. As a result, mutual funds and their clients will have to be prepared to not earn that money back and also to guard against speculative investors hoping to make a quick buck.

India’s surprise seizure of a troubled Indian shadow bank won’t end the woes of its lenders, faced with the risk of heavy writeoffs if Dewan Housing Finance Corp. is declared a fraudulent account.

Only about Rs 5,500 crore of provisions would be required if the KPMG report absolves Dewan of irregular lending, Budhbhatti said.

Dewan has been struggling to repay its loans as the spreading shadow banking crisis has shut off new credit to the sector. The company’s shares are down more than 90 per cent so far this year.

Lenders, headed by Union Bank of India, have formed a committee to discuss a debt resolution plan, which will have to be reviewed by a resolution professional once Dewan is admitted to the bankruptcy court. In February, they appointed KPMG to look into Dewan’s books following allegations by Indian website Cobrapost that the company had diverted funds to shell companies.

KPMG’s preliminary report, a summary of which was reviewed by Bloomberg News, said it was selected to look into Dewan’s accounts for the period between April 2015 and March 2019 to identify any “diversion of funds/misuse of funds outside the business/beyond the uses approved by lenders.”

It said Dewan disbursed loans and advances to “inter-connected entities” and “individuals having commonality with DHFL promoter entities” amounting to Rs 19,750 crore over the period of the study, with a total outstanding amount of Rs 16,500 crore on March 31, 2019.

The preliminary report said Dewan “could not provide a robust and well-defined tracking mechanism for end use monitoring of funds disbursed.” More than half of the connected entities had minimal operations, the report said, though it added that further research was needed as to whether they constituted related parties under the Indian Companies Act.

One way of mitigating the fallout from Dewan, if irregularities are confirmed, is for banks to request special dispensation from the RBI to allow them to provide only for any amounts potentially earmarked as fraud, as opposed to the entire exposure. Banks reported Rs 95,760 crore of fraudulent accounts in the six months ended Sept. 30, according to India’s Finance Ministry.

And while other weak shadow banks would be hurt by the fallout from a total write-off at Dewan, the stronger ones might benefit, according to Gaurang Shah, vice president at Geojit Financial Services Ltd.

It could also be an advantage for strong housing finance companies to garner larger market share and have better earnings.

Satyam Scam

The Satyam scandal was a Rs 7,000-crore corporate scandal in which chairman Ramalinga Raju confessed that the company’s accounts had been falsified. On January 7, 2009, Ramalinga Raju sent off an email to Sebi and stock exchanges, wherein he admitted and confessed to inflating the cash and bank balances of the company. Weeks before the scam began to unravel with his famous statement that he was riding a tiger and did not know how to get off without being eaten. Raju had said in an interview that Satyam, the then fourth-largest IT company, had a cash balance of Rs 4,000 crore and could leverage it further to raise another Rs 15,000-20,000 crore.

Ramalinga Raju was convicted with 10 other members on 9 April 2015. The 10 people found guilty in the case are: B Ramalinga Raju; his brother and Satyam’s former managing director B Rama Raju; former chief financial officer Vadlamani Srinivas; former PwC auditors Subramani Gopalakrishnan and T Srinivas; Raju’s another brother B Suryanarayana Raju; former employees G Ramakrishna, D Venkatpathi Raju and Ch Srisailam; and Satyam’s former internal chief auditor V S Prabhakar Gupta. Ramalinga Raju and three others given six months jail term by SFIO on 8 December 2014

Finding PwC guilty in the Satyam scam, India’s capital markets regulator SEBI on 10 January 2018 barred its network entities from issuing audit certificates to any listed company in India for two years. SEBI has also ordered the disgorgement of over Rs 13 crore of wrongful gains from the auditing firm and its two erstwhile partners who worked on the IT company’s accounts.

After the fraud came to the light, the government had ordered an auction for sale of the company in the interest of investors and over 50,000 employees of Satyam Computers. It was acquired by Tech Mahindra, and was then renamed as Mahindra Satyam, and was eventually merged into the parent company. The Satyam saga eventually turned out to be a case of financial misstatements to the tune of approximately Rs 12,320 crore, as per Sebi’s probe then. Citibank froze all its 30 accounts in 2009.

Raju also manipulated the books by non-inclusion of certain receipts and payments, resulting in an overall misstatement to the tune of Rs 12,318 crore, shows an analysis of findings of Sebi’s probe. As many as 7,561 fake bills which were even detected in the company’s internal audit reports and were furnished by one single executive. Merely through these fake invoices, the company’s revenue got over-stated by Rs 4,783 crore over a period of 5-6 years. The probe itself continued for almost six years and found that fictitious invoices were created to show fake debtors on the Satyam books to the tune of up to Rs 500 crore.

The probe into the Satyam scam has turned the spotlight on banks as investigators and its newly appointed auditors verify the company's numerous accounts. The government is trying to ascertain how much cash actually exists in Satyam's accounts, whether the bank certificates presented to auditors were forged, and whether bank employees colluded with company officials.

Satyam has claimed deposits of nearly Rs 180 crore for the year ended March 2008 in international branches of several global banks. These include Banco do Brasil, BNP Paribas, Citibank, Citibank International, China Merchants Bank, Dresdner Bank, HSBC Bank, Kookmin Bank, KSB Bank, Mitsui Sumitomo Bank, UBS, UniCredit Banca, United Bank, Wachovia Bank and Woori Bank.

The company has stated that another Rs 3,308.41 crore had been parked in long-term fixed deposits. Although the break-up of these investments is not available, Satyam has listed Bank of Baroda, BNP Paribas, Citibank, HDFC Bank, HSBC and ICICI Bank as it principal bankers.

When it comes to its current account details with foreign banks, Satyam's annual report not only lists the opening balance for the financial year against each account held, but also the maximum balance during the year. Interestingly, the company showed a balance of Rs 1,166.89 crore in various current accounts that earn zero interest, which caught the attention of government investigators and regulators. B Ramalinga Raju, former chairman of Satyam, had said that the company had Rs 5,040 crore in non-existent cash and bank balances on its books

The Reserve Bank of India (RBI) has estimated the total exposure of Indian banks and foreign lenders operating in India to Satyam Computers Services and its related companies at around Rs 8,000 crore.

Sources close to the development said that this figure includes the total direct and indirect exposures to Indian and international operations of the companies so far.

After the accounting fraud in Satyam came to light at the end of December 2008, the RBI had sought data from banks, which have direct or indirect loan and equity exposure to Satyam and its related companies or subsidiaries.

Based on the initial findings of the Hyderabad office of the Registrar of Companies (RoC), the government had ordered a probe by the Serious Fraud Investigation Office (SFIO) into the eight companies related to Satyam Computers, which have forayed into other areas such as real estate.

After gathering of data, the banks were advised to write off the short-term loans to the company to maintain the margin amount with broking houses and custodians, to keep the shares afloat in the market, as there has been a sharp fall in the share prices. This situation is more likely now since the market value of the shares have eroded following the sequential events.

However, those who have institutional holdings indirect equity and long-term loans may be asked to follow the usual debt recovery route. Banks may also ask the company to release funds from its vast expanse of real estate holdings. Else, banks may have to book losses on such expsoures on account of fraud if dues cannot be recovered, they said.

Finding PwC guilty in the Satyam scam, India’s capital markets regulator SEBI on 10 January 2018 barred its network entities from issuing audit certificates to any listed company in India for two years. SEBI has also ordered the disgorgement of over Rs 13 crore of wrongful gains from the auditing firm and its two erstwhile partners who worked on the IT company’s accounts.

After the fraud came to the light, the government had ordered an auction for sale of the company in the interest of investors and over 50,000 employees of Satyam Computers. It was acquired by Tech Mahindra, and was then renamed as Mahindra Satyam, and was eventually merged into the parent company. The Satyam saga eventually turned out to be a case of financial misstatements to the tune of approximately Rs 12,320 crore, as per Sebi’s probe then. Citibank froze all its 30 accounts in 2009.

The fundamental question that needs to be asked of the audit and accounting firm, Price Waterhouse in this case, is - why was there such a critical absence of, or failure to enforce, control systems and/or audits in accordance with the firms best practices for such a prolonged period of time? Clearly it is the job of the auditor not only to ensure that companies operate with prudent levels of risk, but also, that their books are subject to an effective and accurate scrutiny regime.

The fact that the Satyam fraud went on undetected and uncorrected for years and without any external audit and accounting mechanism picking it up raises serious questions as to the actual degree of implementation and enforcement of such practices as part of a credible, effective and sound auditing system. Also, given that the audit firm in question was also involved in the affairs of Global Trust Bank and DSQ not long ago, it may be relevant to ask what corrective actions were taken by the firm to mitigate or prevent opportunities for fraud, reckless mismanagement, and conflicts of interest raising the potential for such behaviour within its own organisational set-up. 
 
Clearly, there should have been a clear objective and roadmap within the firm to achieve certain standards of ethics and benchmarking of audit practices after DSQ and Global Trust Bank. In any case, there does exist various annual reviews of frauds and serious irregularities pointed out in several audit reports after the Ketan Parekh fraud in India which should have become a basis for reviewing the basic audit and accounting systems of the many auditing firms.

The second question is whether the Indian authorities can and/or be able to hold the audit and accounting firm liable if serious auditing lapses and accounting irregularities come to view. This question is important as it will go a long way not just to ensure that acceptable, correct and effective audit mechanisms are put in place but also in terms of building the capability within the legal system that puts the burden of serious auditory lapses on the entity itself. The reasons are two-fold.

First, the inability of auditors to detect fraud and the diversion of funds separately or conjointly constitute a key element of the expectations gap between public and professional perceptions of auditors responsibilities and usually gives leads to possible collusion between the auditor and the management.

Second, the inability of auditors to correctly and honestly do their functions often, in turn, result in lack of meaningful corporate governance within the company both in terms of the directors and senior management unable to evaluate and review existing internal control systems through established internal audit functions and/or to implement, enforce, refine and improve upon such internal control systems.

A thorough investigation by the relevant authorities and an effective legal prosecution is the order of the day as it will ensure that honest and correct auditing and accounting methods take precedence, that best practices are meaningfully adopted and followed by audit firms and that the problems of corporate governance are genuinely redressed as opposed to the mere issuance of guidelines that some fail to follow.

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