Thursday, January 8, 2009

Unaccountable Accounting

Accounting is history in perspective. History is written by the winner. Accounts are written by the Managments.

Satyam. This word has been redefined by Ramalinga Raju. In my previous entry, I had touched on corporate governance. One of the accomplices is the accounting profession. Without their help, no management can deliver what they actually do. I doubt if any company would come out totally clean if subjected to forensic accounting. However, the belief is that the accounts are “by and large” a fair representation. There would be a few things buried, either to cover for some promoter/key management “takeaway” from the company or some non-business expenses parked out there. Every perk that is enjoyed for personal use, is, in-principle, pick pocketing of the shareholder. However, the world is by and large generous to a fault, so the accountant agrees and signs on the dotted line.

The accounting fraternity (like any other) is not without its black sheep. There are those who will get you “entries” to launder money from one colour to another, get you ‘expenses’ to lower income and siphon money and generally do your bidding at a price. I am sure all of us have met someone of this breed at some point in our lives. I have met many.

Auditors are a pitiable lot. In a typical audit, the first level check (which mostly comprises of vouching and checking the postings, the accounting heads etc) is done by the rookies. They come out with a list of ‘queries’ which is first discussed with the company’s accounts persons and some are resolved. Where explanations are not satisfactory, the ‘senior’ (who could be a partner or not) takes over. He discusses with the CFO and resolved. After this, the partner who signs will complete the signing formalities. It is physically impossible to check each and every transaction in a large firm. Most of the small things have to be taken on faith and exemplary due diligence and persistence is needed on the big ones. Time constraints and the friendly relations with the client often come in the way and result in compromises. In most cases, the auditor has to rely on his ‘gut’ feel. If he were to fight for every issue, not only will the client be lost, but also the time pressure would be another one. Often, many clients use time pressure as a leverage to push through some black holes.

It is not difficult to con the auditor. In today’s age of electronic banking, there is no “pass book” to verify. An “E” statement (which can easily be generated by anyone) is the bank statement. Bank Fixed Deposit receipts are also in ‘print-out’ forms. This also can be duplicated.

When it comes to sales, when it relates to an industry that suffers no sales tax, excise duty or any levy, it is easy to manipulate. All that is needed is a “contract” from the buyer and the invoice. You can add some or hide some. If you hide, you can divert the proceeds to a bank account that is opened by anyone with access to corporate stationery in the office. The beauty is that the auditor can only check what bank accounts/invoices are disclosed to him. There is no way to cross check. I can easily list over a hundred areas where things can be manipulated.

However, checking what is on the records should be a simple matter. In the old days, the auditors would insist on “balance confirmation” letters from bankers and debtors. The debtors sometimes do not respond. This is taken as a routine exception and no reportage happens. The practice seems to have been discontinued.

The point is that whilst there is no excuse for an auditor, the truth is that he can only be as good as the management is. A structured fraud can put paid to the best of the auditor.

The other aspect is one of knowledge of industry. Can the auditor have skills to verify the entire inventory? He can count the cash balance and verify the bank balance. Outside of this, the auditor generally does not have the expertise to check the logic, the margins etc. He can do some peer comparison of key ratios. Similarly when it comes to capital expenditure, consulting fees or any other similar matters, he has no clue. At best, he can see if there is a practice of some kind of comparative quotes that the company has obtained and check with that.

The more important issue here is one of the auditors engaging themselves in other fee earning activities from audit clients. This generally leads to conflicts as well as compromising on audit fees. In fact, in small companies and in large institutions like banks, the audit fees seem woefully inadequate in relation to the size of the business. I also wonder about what level of audit can be done in a three-month period for a bank that has a few thousand branches.

The whole thing again falls back to ‘faith’ in management. If you study any ‘Auditors Report’, you will notice so many disclaimers, which it almost amounts to an admission of total faith on the management.

I would urge the accounting profession to do the following:

1. Co-opt people who are not auditors on your governing board. These could be financial analysts with CPA, investment managers with long standing and some one from regulatory bodies like SEBI;
2. Raise the fees sufficiently to do a thorough job;
3. Ban any kind of activity other than pure audit. If consulting has to be done, then give up your Certificate of Practice and then do so. No accounting firm should have any other business;
4. Streamline the audit process in view of some lessons learnt from the Satyam affair;
5. Realise that you are working for the shareholders and not for the management. Have the balls to blow the whistle where needed.
6. Insist on compulsory rotation every two years or so;
7. Where the company is of a large size make ‘continuous audit’ mandatory.
8. Make a minimum of cross checking with counter parties mandatory. It could include vendors, customers, consultants etc
9. If a firm is caught in negligence or malfeasance, apart from debarring, give wide publicity to the fact so that the person/s involved never get any employment. Also make it illegal for any listed company to employ such a person in any capacity for life.

The regulators can also do something. Move this gamut of crime from civil to criminal. It is strange to see petty pickpockets rotting in jail and Wall Street criminals enjoying free air and investigations never reaching to any conclusion. The Fraud Office orders should be given judicial standing, so that only the Supreme Court can overturn/rule on it.

To the public at large, my advice is to depend more on the managements rather than on accounts alone. Accounts are important, for that tells you what your rupee does. However, accounts as you see are the result of a lot of makeovers that are given to make them appealing. Management reputation is a subjective thing. No doubt Satyam had a great image, with an accounting firm having chosen it for an award!!

I am sure that the Satyam saga is much more than the simplistic accounting fudge explanation given in the letter. The story has to be far more complex than that. But it has thrown the spotlight on the audit fraternity. I am sure that Satyam is not the last we have seen.

January 8th. 2009.

No comments: