Time for India to move on to next level of audit compliance after Yes Bank, PMC Bank failures

By Vivek N Gour

It is a pity that Boris Johnson decided not to travel for India’s 72nd Republic Day celebrations. A dilemma, which the Government could have done without. Proposals from UK Government’s Department of Business, Energy and Industrial Strategy (BEIS) on corporate and governance reform can however assist in resolving other dilemmas back home. Given the shared history, India has naturally taken cue from UK in designing its governance, economic and institutional models. From two tier parliamentary system to electricity boards (including their subsequent reform, still a work in progress in India) and the shared passion for cricket and curry are all well known.

Both economies also share a rather ignominious feature – recurring corporate scandals. The recent ones in UK include Carillion, Thomas Cook, Patisserie Valerie amongst others. In India, the list includes IL&FS, Jet Airways, Café Coffee Day, amongst others. There are several similarities, apart from the fact that Carillion and IL&FS were in infrastructure and construction, Thomas Cook and Jet in travel and hospitality and Patisserie Valerie and Café Coffee Day operated retail chain of cafes.

Take the example of Carillion and IL&FS. Carillion, one of UK’s largest construction firms collapsed spectacularly in January 2018. It was a sudden fall that jeopardized about 20,000 jobs and put to risk many pensions. It was UK’s largest insolvency with Carillion’s liabilities exceeding $9 billion. IL&FS’s fall was also sudden, as it went from AAA to junk in less than six months, with a debt of over $12 billion.

A report by UK’s two Parliamentary Committees was scathing in criticism of the directors, auditors and regulators. The words used to describe the directors were “reckless, hubris and greed”, who prioritized personal financial interests over the organization’s survival. Sandeep Hasurkar, an investment banker, with several years in IL&FS’s energy vertical uses similar words in his recent book, “Never Too Big to Fail: The Collapse of IL&FS and its Ten Trillion Rupee Maze”. His book claims to provide detailed insights into the grandiose objectives purported by the directors but shallow, flawed decision making; of notable achievements in early years followed by devastating failure; of grandstanding hubris and myopic self-interest; of systemic blindness and tacit complicity; of fiduciary responsibilities and failures of risk management and corporate governance.

The directors of both Carillion and IL&FS have been uniformly criticized and are now under investigation in respective countries. However, UK’s Parliamentary Committee’s strongest criticism was directed to the accountants. The Committee notes that Carillion’s accounts were systematically manipulated to make optimistic assessments of revenue. KPMG was paid £29 million to act as Carillion’s auditor for 19 years. However, it never qualified its opinions to flag the risks and signed off the numbers produced by directors, which were progressively bizarre.

A key point in the entire Carillion saga relates to the conflict of interest in appointment of auditors and consultants. British MP Heidi contended that PwC’s involvement in multiple aspects including working for Carillion till late 2016, advising pension fund trustees and Government will appear to the outside world as a massive conflict of interest. This is so because most of their revenues were derived from consulting services. For example, in the UK, they now earn less than a quarter of their income from the auditing business. Deloitte – the Carillion internal auditor, that “failed in its risk management and financial controls role” – earns only 14% from auditing.

The case of IL&FS auditors is very similar. India’s National Financial Reporting Authority (NFRA), the independent regulator for auditing profession and accounting standards, recently declared the appointment of Deloitte as the statutory auditor of IL&FS Financial Services as an illegal act. The main charge relates to ineligibility due to conflict of interest and that Deloitte was not eligible to be appointed as it violated Sec 141(3)(e) (subsisting business relationships on the date of appointment) and Sec 141(3)(i) (provision of non-audit services directly or indirectly) of the Companies Act, 2013v. This followed a previous order of NFRA imposing a 7-year ban and a monetary penalty of Rs. 25 lakhs on Deloitte’s former CEO for professional misconduct, specifically highlighting that independence of mind and appearance of statutory audit was totally compromised and noting a serious lapse in discharge of duties, intentional recklessness, and collusive behavior to fraudulent presentation of the financial statements. It appears that lessons from Satyam fraud a decade ago are yet to be learnt. Mr. Deepak Parekh appointed on the Board of Satyam as part of the crisis management effort is on the record stating the negligence of the auditors (Price Waterhouse) in the case. A subsequent investigation by market regulator SEBI revealed “glaring anomalies” and “systematic problems” in the audit process leading to a 2 year ban and a disgorgement order.

UK has since initiated a series of measures including a detailed inquiry titled “Delivering Audit Reform”. This has been a work in progress under the Chair Darren Jones of BEIS with several rounds of consultations completed. He commented in the last meeting “that it was vitally important that investors and other stakeholders have confidence in audits. Confidence has been shaken in recent years by a series of audit scandals. The Government and the regulator now need to step up and help improve corporate governance, boost audit quality and tackle competition in the audit market by pressing ahead with the practical measures recommended by a series of reviews”. BEIS is expected to deliver over 100 recommendations early in 2021. These are likely to include creation of Audit, Reporting and Governance Authority (ARGA), break-up of audit and consulting business, amongst others.

Building trust in governance systems and the private sector is even more critical for India, which according to Arvind Subramanian (ex-Chief Economic Advisor) has been facing the curse of “stigmatized capital”. Similar theme was also echoed in the Economic Survey 2020, stating “…India’s aspiration to become a $5 trillion economy depends critically on strengthening the invisible hand of markets together with the hand of trust that can support markets…”. Given the recent history of multiple audit, finance and governance failures such as Yes Bank, PMC Bank, DHFL amongst others, time is ripe for India to graduate to the next level of corporate governance.

We can draw inspiration from our own rich history. Kautilya, also known as Acharya, recognized the importance of accounting methods and that a proper measurement was essential for efficient allocation of resources. Prof. Balbir S Sihag, an emeritus Professor at MIT notes that Kautilya developed bookkeeping rules to record and classify economic data, emphasized the critical role of independent periodic audits and proposed the establishment of two important but separate offices – the Treasurer and Comptroller-Auditor, to increase accountability, specialization, and above all to reduce the scope for conflicts of interest.

We need to consider several steps, including reform in functioning of the Boards, role of the management and appointment of auditors, amongst others. The Board of Directors, together with the Management are responsible for the governance, strategy, and operations. Therefore, governance reform needs to start with appointment of truly independent, competent and respected directors. Equally important is the process of an honest evaluation of their performance and subsequent training and certification. Expertise, autonomy and transparency at the Board can reduce the agency cost. In professionally managed companies with weak boards the agency cost can be inflated as management can wring out unjustifiable compensation for themselves, use company’s resources for personal benefits or collude to report doctored results. Many of these challenges were cause of downfall of Carillion, IL&FS, Yes Bank and other companies. The Uday Kotak Expert Committee, established by SEBI, made a series of recommendations. While several were accepted, many remain unimplemented and others need cross-agency co-ordination.

Even more relevant steps are needed to modify the behavior of auditors and credit rating companies. Early in 2020 the Ministry of Corporate Affairs published a Consultation Paper to examine the existing provisions of law and make suitable amendments therein to enhance audit independence and accountability. It highlighted that time and again, audit independence has been questioned and called for a review because the auditor’s financial or other interest in client’s business inappropriately influence his judgement or behavior and a conflict of interest always exists. Implementation of these provisions will likely require an amendment to the Companies Act. Similar issues mar the credit rating industry, given the possibility of adverse selection or “rating shopping” by managements. SEBI tightened regulations relating to rating agencies in 2019 to an extent, but further steps to benchmark to international best practices are desired. BEIS report expected in near future may have some relevant lessons for India.

Marie von Ebner-Eschenbach, renowned Austrian author, once said, “In youth we learn; in age we understand”. Economic failures generate new understandings and lessons, irrespective of geographies and sectors. There are lessons for all. UK is learning theirs. We need to learn ours.

(Vivek N Gour is an independent director with 17+ years of experience as a Board Member of large operating companies. He serves on the Board at IndiaMART, Affle India, Cyient and ASK Investment Managers as the Chair of the Audit Committee. Views expressed are the author’s own.)