“Indian promoters have a mindset that they are not accountable to anyone.” – Accounting Fraud in India: The Indian Context

http://tejas.iimb.ac.in/interviews/11.php

ACCOUNTING FRAUD : THE INDIAN CONTEXT

with R. Narayanaswamy, Professor

The past few years have seen several headline-grabbing incidents of corporate fraud in India. There were the Harshad Mehta and Ketan Parekh cases, followed by the Unit trust of India case. And now, we have seen the Satyam and World Bank-Wipro cases that have not just tested the Indian business framework, but also sent ripples across the global scene. It is imperative that we take notice of this growing systemic problem and understand its motivations and methods. In this interview with Prof. R. Narayanaswamy, faculty in the Finance and Control area at IIM Bangalore and a veteran in accounting, we take a closer look on the cases at hand, concentrating on accounting fraud in India but examining it from different perspectives.Recent Fraud in India

Tejas: We have seen stunning cases of financial fraud over the last few years. How are such large players, with public reputations, able to commit large scale fraud despite the prevalence of auditors, regulators and shareholders overlooking them? Is it a classic case of the agency problem? What other factors may be at work?

RN: In fact, there is nothing new about financial fraud. Unlike what most people might think, there is also no pattern to these frauds; it can happen in any country, any type of firm, regardless of type of ownership. But if we are to address the issue of how the management of these firms is able to get away with fraud, we should probably look at all the people responsible for tracking it down. Companies are often able to arm-twist auditors. Also, auditors get very good business from large clients and may put in less effort to confirm suspicions in the fear of losing business. Let us take Satyam as an example. It is mystifying why auditors did not spot invoices without time stamp, or did not come to know of any “ghost” employees. Even at WorldCom, revenue expenses of $10bn were capitalized, something auditors can’t easily miss. Whether it is a case of negligence, incompetence, greed for business or complicity in the crime is not clear, but it would be unfair to make allegations without substantial proof. While it is true that regulators and auditors not catching fraud is a serious issue, there are market participants who must also share the blame for failure. Analysts and the company’s bankers too are privy to enough information that can lead them to raise an alarm, if they care to. To this end, information sharing amongst banks and other financial institutions would be helpful. Angel Broking was reported to be queasy about certain dealings within Satyam, but they were largely the lone voice. None of the bigger research firms raised doubts about Satyam.

Tejas: How is the context for financial frauds different in India? Does family ownership have anything to do with it?

RN: Certainly the situation is different in India. And family ownership does complicate matters a great deal. However, analysts, auditors, rating agencies and other intermediaries are more than aware of the family ownership issue and hence should be all the more careful. Family ownership sometimes makes it difficult to see who is really in charge. Sometimes the family puts up a person as a “front” and gives him an impressive title but he may be acting at the family’s command. However, it is not fair to say that firms with family ownership are more prone to fraud. It often works the other way too. Many families have reputations to protect. Wipro is virtually a family-owned enterprise, and it has an excellent reputation. There are many examples of perfectly professional firms also going down the path of fraud. So generalising is risky.

Tejas: Is stock-based incentive an issue? Then there is also pressure from shareholders. Is it possible that pressure from shareholders to over-perform may induce business myopia in the management and push them towards fraudulent practices?

RN: Stock-based compensation was blamed for the dotcom bust as well. It is a fact that stock options mostly make the management myopic. Managers look for immediate gains, often ignoring what may be good for shareholders in the long run. However, managers are not really the only ones responsible for the myopia, even with the stock options. They are also under tremendous pressure from founding families (“promoters” as they are known in India) and large institutional investors. Also, I feel sometimes this is a political issue. Politicians need someone to pin the blame on to deflect the public anger. This issue of senior management being endowed with lucrative options is often made a bigger deal of than it really is because of this.

Tejas: Can you shed some light on whether mark-to-market accounting could encourage fraud by say, letting the management artificially push up accounting profits and off-load their stock?

RN: The jury is still out on the issue of mark-to-market (MTM) accounting or more generally fair value accounting. But this too is a target of the politicians who need something to blame. At the time when profits went up beyond expectations (during boomtime), the same practice of MTM accounting made companies dish out higher taxes to the government. How come the governments kept quiet about the practice then? Nobody wants to rock the boat when the economy is booming. When the slowdown comes, suddenly everyone is against MTM. It is true that some products with little or no market cannot be valued accurately (Level-3 products in fair value accounting terminology), and may be better valued with other methods, but by and large, it is not fair to place more blame than necessary on MTM.

The Role of Regulation

Tejas: The Enron case led to the enactment of the Sarbanes Oxley Act in the U.S. Clause 49 in the listing agreement is exactly the same in India. However, given the predominantly family owned nature of most Indian firms, is it right to replicate the same law here without modification?

RN: Do not attempt to drive a Ferrari on Indian roads. Clause 49 is imported, partly from the Sarbanes Oxley Act and partly from similar European clauses. But Indian business works differently. Indian promoters have a mindset that they are not accountable to anyone. In this culture, capital markets really cannot be much effective as a monitoring mechanism. Also, we have seen how even some CEOs in India are on other companies’ boards. So many that they can give time to any of them. There exists an “I-serve-on-your-board, you serve-on-mine” network of independent directors. Given such problems, I doubt if the provisions of the clause would be really effective.

Tejas: There is talk that the RBI, SEBI and other government agencies plan to bring in new regulations . Yet, these seem to remain on the burner and there is scepticism as to whether they will actually be passed. Why are we unable to force these through the government’s systems?

RN: We don’t really need more laws. There exist more than enough legal and regulatory provisions. On a lighter note, if someone were to carry the Companies Act document for a few minutes he would likely develop a condition called tennis elbow. More important than any of these laws is their implementation. Can the government effectively enforce the laws it passes? According to a report, over a 1,000 companies listed on the Bombay Stock Exchange (BSE) have not filed the corporate governance compliance certificate, a necessary condition for continuing to be a listed company. If they are not able to enforce existing laws, passing new ones is not going make any difference. As for a few laws being on the back burner, there could be any number of reasons including some very Indian ones. For example, a set of accounting standards to be notified by the government got delayed a lot because the Hindi translation of the standards was not ready, and the standards were eventually notified in December 2006.

Tejas: Do you believe there is a need to put in place an independent and autonomous board to oversee the role of auditors? In the US, the Public Company Accounting Oversight Board (PCAOB), created under the Sarbanes-Oxley Act (SOX), oversees the role of auditors; this body has investigative and disciplinary powers, including the imposition of monetary penalties and even the revocation of registration.

RN: The Companies Bill 2009 proposes a national advisory committee on auditing and accounting standards. But the PCOAB applies only to listed companies. So perhaps in India SEBI might be the right body to assume this responsibility. The ICAI has often proved to be a closed club but SEBI on the other hand has been very innovative and pushy. Whether it is quarterly reporting, segment reporting, cash flow statements, consolidated financial statements or the latest initiative to publish consolidated statements according to IFRS optionally, SEBI has been acting fast. In other words, we need a professionally run organisation for this purpose and a body like SEBI may just be the right one.

Tejas: The perspective today is that an auditor’s tests are not designed to detect fraud in the normal course. Instead, they give reasonable assurance on the financial statements as against a certificate of correctness. It is the management, under various laws including the Companies Act and Clause 49 of the Listing Agreement, that is responsible for maintaining books of account that reflect the true state of affairs and the income of a company. Do we need an drastic change in perspective?

RN: Auditors say they are meant to be watchdogs, not bloodhounds. And to some extent they are right. It would be outside of their role to look out actively for instances of fraud. However, they should probably be on the lookout for conditions that are conducive for fraud. Examples of such conditions would be excessive interference by dominant owner, lack of sound internal controls, arbitrary allotment of responsibilities, a high degree of centralisation of power in the hands of the CEO, and so on. Even if no fraud is detected, such conditions must be mentioned in the auditor’s report. It is worth revisiting the recommendations of the Treadway Commission on Fraudulent Financial Reporting in the 1980s.

The Role of Technology

Tejas: Has the advent of technology, and the ease with which one can conduct transactions electronically or maintain records in digital form, made detection tougher?

RN: Technology has allowed us to run a paperless office and leave no paper trail of the work we do. This makes life easier for fraud perpetrators. Given that electronic data processing is most common these days, we need to have accountants who have a comprehensive understanding of the way information technology works and about how software querying of data takes place. The day might not be too far when we will have IT professionals taking up accounting and auditing. This apart, the digital age has brought a set of risks which makes comprehensive understanding of business and risk management a prerequisite. In sum, the advent of technology has definitely made detection more challenging than it was and we need inter-disciplinary approaches to manage the risks.

Tejas: An increasing number of cases of fraud are today linked to ghost-pay rolling happening in companies. This is made all the more easy with automation. What are the measures you would suggest to prevent this?

RN: Ghost pay-rolling may be more prevalent in firms with large numbers of employees, especially the ones that require spending time on client sites offshore. This is typically what could have made the cover up at Satyam possible and easy to perpetrate. Further, the profusion of casual labourers and contract employees in companies results in a large number of workers who are not captured in the payroll. Automation seems to have contributed to this problem, since the old systems of physical payment have been phased out and employee payments are done using software that credits bank accounts automatically. However, ghost pay-rolling on a large scale cannot be done without the knowledge of the top management. Banks also have KYC (Know Your Customer) norms, so how do companies manage to pay the salaries of fictitious employees?
There may be several kinds of ghost employees. They may be real individuals but not working in the company. They may be fictitious. Solutions could include techniques such as biometric identification and age-old techniques such as administration of a head count that shall help physically verify the existence of the individuals. Finally, if banks are not strict in implementing the KYC norms, it might become easier to prevent fraud of this kind.

Looking Ahead

Tejas: Can the fact that the alternative minimum tax/direct tax changes are being brought in affect this scenario even further?

RN: Taxation creates income-decreasing incentives. The minimum alternative tax (MAT) based on accounting profit discourages managerial overoptimism in financial reporting. But this may not be the best way to solve the problem. In any case, the objectives of accounting and tax are different and we should not look to the tax law to improve accounting quality and integrity. The draft Direct Tax Code proposes assets rather than profit as the basis of determining MAT.

Tejas: Do you see a rise in the practice of forensic accounting in India, as forensic accountants aim specifically to act as bloodhounds to detect possible accounting malpractice?

RN: Forensic accountants add value through their understanding of business, financial reporting, accounting, auditing, and gathering of evidence, investigation and litigation procedures. They also play an important proactive role in risk reduction by administering elaborate procedures as part of the statutory audit and fraud deterrence. Thus forensic accounting plays an important role in both preventing and detecting fraud. However, Indian companies are yet to embrace it. Forensic accounting must be made a preliminary requirement that clears the company of any suspected fraud. In fact, all the major auditing firms must be able to carry out forensic accounting through a separate department. So ideally, only after the forensic accounting division clears the company of any suspicion, should the audit division start its work.

Tejas: What changes do you expect to see in the near future, with respect to regulations, accounting standards/practices?

RN: There are a lot of reforms that are expected and are underway even as we speak. These include stricter implementation of KYC banking norms, Director & Officer insurance, more stringent audit measures, and stricter regulatory vigil. We could think of many more. For example, there can be a requirement that practicing CAs should have a sound understanding of IT systems. There should be greater payment for auditing services in keeping with the important role auditing plays in the markets and in the society. We can think of auditing as a utility, similar to electricity and water, and assure a reasonable rate of return to the auditing industry. Improving the technical competence of independent directors is important. An Indian equivalent of the PCAOB is necessary. Systematic and predictable action on violation of the law is important. The recent arrest of a senior officer in charge of deciding company cases on bribery charges tells us a lot about the state of affairs. Fixing the system is not easy but it has to start soon.

Conclusion

Despite the issue of Indian companies being family owned, accounting fraud in India, has nothing new about it, except perhaps the ways in which it has been perpetrated. The latest cases of accounting fraud seem to involve aspects of stock based incentive and mark-to-market accounting. However, the techniques to curb fraud must continue to involve tracking down all people who hold stakes in the business- those who stand to gain in case there is an inflated opinion about the performance. As for the regulations themselves, it is perhaps not necessary to bring in new regulations by the dozen- it is more important to understand the mindset of the Indian fraudster, bring in meaningful regulations that are not aped versions of their US and European legal counterparts, to administer and implement them more effectively and to understand that technology can both help and hurt our case, as we take our battle against accounting fraud to the next level.

Profile

Prof. R Narayanaswamy is a Professor in the Finance & Control department at Indian Institute of Management, Bangalore. A PhD from The University of New South Wales, Sydney, he also holds a B. Com. from St. Josephs College, University of Madras.
His research topics include Corporate Disclosure Policy, Voluntary Adoption of US GAPP and IFRS, Corporate Governance and Earnings Management. He has written leading books on Financial Accounting and Financial Reporting. In addition to this, the Professor has been a consultant to ANZ Grindlays Bank, Barclays Bank and Kingfisher Airlines to name just a few.

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