Auditors and fraud

We need to look at the entire ecosystem to minimise corporate frauds and not just focus on auditors

On February 6, the Ministry of Company Affairs (MCA) came out with a consultation paper on what could possibly be far-reaching changes to the auditing profession. In addition, the MCA, by its order dated February 25, mandated that auditors need to report on nearly 30 more matters on Company Auditor’s Report Order (CARO). All this because of the in­ability of auditors to detect fraud? In the fight against corporate fraud, we need to be realistic and understand that it will never be possible to ever arrive at a zero-fraud situation. Fraud can at best be controlled but not eradicated. We need to realistically look at the entire ecosystem of auditors, independent directors, audit committees, finance managers, system of justice, whistle-blowers, rating agencies, banks and regulators to minimise the occurrence of frauds in corporate India, and not focus exclusively on auditors.
 
Every business failure or fraud is not an audit failure. Regulators have taken a very aggressive approach against auditors. We have multiple agencies regulating auditors, such as the MCA, Sebi, RBI, SFIO, NFRA, ICAI and ED often with overlapping jurisdiction. We have charge sheets against auditors not only for the failure to detect fraud, but also for having actively connived with the perpetrators of the fraud. A financial audit may or may not uncover intentional fraud. Auditors are not insurers. Every business failure or fraud is not an audit failure. Regulators need to move with care and caution in levying charges of collusion based on strong and conclusive evidence. Moreover, regulators should have domain knowledge and be familiar with all the current accounting and auditing standards to ensure fairness and objectivity in the process. An informed view needs to be taken before throwing the book and cracking the whip against auditors.
 
Voluntary ban on non-audit services by the auditing profession is a gigantic step. The audit profession has taken a remarkable step forward in that certain big firms such as Deloitte, PwC and Grant Thornton have volunteered not to undertake any non-audit services, like consulting, due diligence or any other advisory service for their audit clients. This voluntary action is self-regulated and extends beyond non-audit services permissible under the prevailing regulations. No country, except the UK has such a ban. This is a gigantic step forward by the auditing profession. The audit profession needs to further examine the feasibility of an operational split between audit and non-audit services with separate CEO and board for each. 

Illustration: Binay Sinha

In the USA in the early 2000s a number of frauds led to major reforms like the Sarbanes-Oxley Act and the Public Company Accounting Oversight Board (PCAOB). The frauds at Enron, WorldCom and Madoff led to swift and heavy prison terms for the culpable parties. Jeffrey Skilling of Enron was put in a federal prison for 24 years, Bernard Ebbers in WorldCom for 25 years and Bernie Madoff in the Madoff Ponzi Scheme for 150 years. Contrast this with the self-confessed Satyam fraud in 2009. The conviction took six years and the culpable party is out on bail having served 33 months in prison. We need to look beyond statutory auditors, independent directors and audit committees, at measures to reform and invest more in our system of justice as a deterrent against future corporate frauds and have laws that focus on enforcement and justice that catch the crooked. 
 
Whistle-blowers policy is another area of reform required in India as a deterrent against frauds. Famous frauds are replete with successful whistle-blowers. Sherron Watkins in Enron; Dinesh Thakur in Ranbaxy; Singaravelu in Tri-Sure who informed about the secret godowns. More recently, whistle-blowers have alleged wrongdoing in Infosys and Sun Pharma. Indian law does provide for whistle-blower complaints to be looked at by the audit committees of the concerned companies, but there is no separate whistle-blower act, like the one in the USA and there is no separate agency, like the Office of the Whistle-Blower Protection Programme. The USA law provides greater anonymity and protection from victimisation than Indian law. 
 
Finance Managers are required by law to certify the financial statements. We must go further and levy greater penalties and make them criminally liable for frauds. Material frauds are unlikely to take place without the active connivance of finance managers. It is the finance managers and their team which pass the bogus entries to mask the fraud at the instance of the perpetrators and mislead the auditors and audit committees.
 
The withdrawal of the Tata Finance Special Investigative Report in 2002 led to a raid of the audit firm by the Registrar of Companies to seize files related to the special report on the belief that documents were being destroyed. This was reported by the media. After investigation by the regulator, absolutely no destruction of records was found, but the damage had already been done. This was a heady mix of sensational news and vilification of the audit firm in the media — a trial by media headlines. Today, the SFIO and the Sebi have even greater powers to issue charge sheets or orders against auditors and independent directors that can damage reputations and therefore should be used with maturity and careful consideration. We need accountability from regulators and less top down regulation regardless of their effectiveness and consequences. Bureaucrats have an impulse to overregulate as in the case of the recent CARO order.
 
The requirement for independent directors’ registration with unnecessary details before February 29 by MCA, is another example of irritation and overkill. Professionals and others who value their reputation may now refuse to seek careers as auditors, independent directors and members of audit committees. They will avoid or resign from companies where they ascertain regulator risk, as has already started. This will be a retrograde step for such institutions. Let us not pronounce persons guilty without cause or attach their assets or we may end up without the sufficient number for the over 5,000 listed companies in India.
 
In conclusion, the government and regulators have to work with all impacted parties to find solutions to these concerns and ensure that the relevant institutions mentioned above are strengthened and not weakened. In addition, we have to look at other targets for reforms, like our system of justice, whistle-blowers and finance managers as deterrents to corporate frauds. The growth rate of the Indian economy is sluggish, hovering at 4.8 per cent and we have the highest rate of unemployment in 45 years and at this time, more than any other time, India needs a favourable foreign investment climate with an enlightened regulatory system.
 
The writer is a former senior partner of A F Ferguson & Co. and was involved in the Tri-Sure case and Tata Finance special investigative report