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A blind watchdog: Auditors must do better to prevent fraud, financial crime

Rajesh M. Kayal
A blind watchdog: Auditors must do better to prevent fraud, financial crime

Recent scams in various large entities have displayed the inability of auditors to report fraud to the owner/shareholders. (File photo)

The word “audit” is derived from the Latin word “audire”, which means to hear. In the process of an audit, fraud risk will be one of several risks that are evaluated. In 1986, in the case of Kingston Cotton Mills company, it was stated that the auditor is a watchdog, not a blood hound. His responsibility is to find the true and fair value of the business and provide details of errors and fraud. The duty of an auditor is not to harm. The remedial action has to come from the owner of the entity in question.

Recent scams in various large entities have displayed the inability of auditors to report fraud to the owner/shareholders. In most of the cases, the magnitude of the fraud is in the thousands of crores. In the NSEL scam, a default to the tune of Rs 5,600 crore exists. Around 13,000 trading clients were affected and their money was stuck for more than six years. The failure of the auditor to detect the fraud and report it is the main cause for these losses. The auditors, Shravan Jalan and Amit Kabra have been arrested six years after the fraud was committed.

More recently, in the IL&FS case, lenders and shareholders lost about Rs 3 lakh crore. In the PMC bank scam more than Rs 4,300 crore worth of loans were extended to HDIL through bogus accounts. The auditors could not detect — or detected but did not report — fraud committed in earlier years. The PMC scam is a painful incident as middle-class people lost their hard earned money and retirement funds deposited with the bank. About 10 people died/committed suicide as they lost their life savings. All the auditors of the bank have been arrested.

But there are number of companies where the market capitalisation lost is much less, in lakhs of rupees. No auditors were arrested in most of these cases. Then there are frauds committed in the nationalised banks and not reported in time by the auditor. For such scams, the onus is on RBI auditors as well.

Is the most commonly performed annual financial audit to be relied upon to detect fraud? Or is total negligence on the part of the auditor the culprit? Or is she/he also a party to the fraud? These questions need to be answered before designing the new system of audit reporting.

SEBI recently issued a circular to discourage the auditor from resigning midway through an audit, instead of reporting the lapses. There is a government plan to revise the company auditor regulation order 2016 (CARO 2016). There are various steps being taken to improve the reporting, especially about the use of borrowed funds and to report on critical financial ratios. These may help to some extent but will not solve the problem entirely.

The Institute of Chartered Accountants (ICAI) has its own disciplinary committee and the power of a civil court to try professional misconduct. The ICAI has failed completely in controlling the misconduct of its members. Some elements involved in misconduct and fraud are ruining the ICAI’s reputation. The National Financial Reporting Authority (NERA) has largely taken over the powers of ICAI to regulate auditors. It will make stricter rules for the audit firms, increasing compliance and reporting. The time has come to review the entire reporting system and introduce stringent provisions before it is too late. Arresting the auditor is only part of the remedy. For the depositors, this will not help recover their lost money.

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The ICAI should make stringent provisions and rules for reporting by the auditors. Merely increasing compliance is not going to help. Auditors have failed in their basic duties. The law should be more stringent. Auditors should not only be arrested but their assets confiscated and they should be treated as party to the fraud along with the management. There needs to be a separate provision in the Indian Penal Code for maximum punishment and speedy disposal for such financial crimes.

The government should think of a better alternative to the ICAI and SEBI. There should be an entirely new regulatory body to protect against frauds of the sort we have been discussing. It is well said that prevention is better than cure. There is no use of crying over spilt milk. In the current system, actions are often taken after the investors suffer huge losses. It’s time to think about preventive measures.

This article first appeared in the print edition on February 15, 2020 under the title "A blind watchdog". The writer is a chartered accountant.

Opinion: Follow the money