After being quite lenient, thanks partly to a sluggish oversight body, the government is cracking down hard on audit firms. While the last big action taken was against Pricewaterhouse Coopers (PwC) for not detecting the Satyam fraud even while it was its auditor—Sebi banned it from auditing for two years and fined the firm `13 crore—a few days ago RBI banned EY affiliate SR Batliboi from auditing banks for a period of one year, and now, the government has approached the NCLT for a five-year ban on audit firm Deloitte Haskins & Sells and KPMG affiliate BSR & Co for their alleged role in the IL&FS Financial Services (IFIN) meltdown/scam.
The government has tightened the rules, so apart from compulsory auditor rotation, the law now says that the parent firm will also have to bear the liability in case of audit negligence/fraud; a new regulatory body, the National Financial Reporting Authority (NFRA) was also set up once it was found the existing oversight body, the ICAI, wasn’t really taking much action against erring auditors/firms. Given the spate of NBFCs—not just IL&FS—whose accounts are turning out to be much worse than imagined, and the serious flaws in audits of bank defaulters that detailed forensics have now revealed, it is not clear that the changes have had the desired effect; NFRA is, of course, relatively new.
What has happened, though, is a flurry of auditor resignations, possibly due to the fear that, this time around, the government/NFRA will take action. According to NSE Infobase, while 12 firms’ auditors quit in both 2016 and 2017, this rose to 48 in 2018 and 14 in the first half of this year. PWC is the latest to resign, as an auditor of Reliance Capital and Reliance Home Finance. While the two firms have said that they have furnished all necessary clarifications/documents to PwC, the auditor maintains that Reliance Capital had not convened an audit committee meeting on time; PwC also said it had not received a satisfactory response to its queries.
While the charge in the IFIN case is that the two audit firms colluded with IFIN’s management to hide the details of bad loans, the net could widen further since, while IFIN had a large amount of hidden debt, much worse happened in the case of the parent firm IL&FS where auditor fees rose from `4.5 crore in FY15 to `15.9 crore in FY17, before falling to `13.7 crore in FY18. The IL&FS annual report for 2018, for instance, stated that the company’s net profits for the year were `584 crore within the first few pages, but it took till the 210th page to know that group incurred a net loss of `1,869 crore that year. And while the company’s borrowings are `15,935 crore, it is only in the consolidated balance sheet—also in the same annual report—that you get to know the group debt is `106,483 crore. While reporting the data, the auditor says there are 141 subsidiaries, 12 associates and 26 joint ventures whose accounts were audited by other firms, and, additionally, it did not audit the financial statements of 18 subsidiaries, 6 associates and 17 joint ventures.
You would think that, given that the auditor knew that there were such a large number of subsidiaries and related entities where close to `90,000 crore of debt was parked, it would have flagged this and pointed out that it needed to audit the step-down subsidiaries as well. And surely the auditor was derelict in not pointing out, upfront, that the rosy financial ratios in the annual report meant little once the overall group picture was looked at?
It is, of course, also true that given the financial jugglery many firms such as IL&FS indulge in, auditing has become a lot more complex. The latest report on India’s NBFCs by market intelligence firm REDD points out, for instance, that several of these high-profile firms use what they call ‘box companies’ to hide loans/debt and to avoid regulatory requirements such as on capital adequacy or exposure to related parties. As REDD puts it, “By using the box structure, we also reckon that some of these companies have found an alternative to the concept of a rollover or evergreening …Banks and NBFCs just lend to a new proxy/dummy entity which advances funds to the borrower entity to repay the loan to Banks/NBFC, avoiding reporting NPAs and a knock-on effect on equity multiples”.
While the authorities need to examine the intricacies of these structures and the fund flows that REDD details, the government also needs to revisit the issue of how many layers of subsidiaries should be allowed; IL&FS had 347 entities held via four levels of step-down subsidiaries; and there were 142 entities at level 4! And while the government is penalising auditors, no action has been taken against the company’s independent directors—the risk management committee, headed by the LIC managing director, met just once in three years, years when the consolidated debt almost doubled.
And, while it is true that the rating agencies also gave IL&FS a good rating by failing to look at consolidated accounts, they weren’t the only ones at fault. Apart from the fact that regulators like RBI were napping, it is shocking that Sebi was willing to put in abeyance its August 2017 circular that made it mandatory for all listed companies to disclose all defaults in payment of interest and repayment of the principal within one working day. Not only did RBI fail to realise what was happening in IL&FS despite it being classified as a systemically important company but also it continued to push for not making names of defaulters public along with the dates of default—without 24×7 defaults data, how can a rating agency construct a model to predict default? Nor did any regulator insist that all firms be forced to put out some basic group-level data. With India being rocked by one NBFC crisis after another, the least one should expect is that the government will come out with a comprehensive solution, and take more than action on banning auditors.