Do corporate awards misguide public?

I want to ask you a few questions. Have you ever thought of a company as a good investment prospect after seeing the awards it has received? Do you form a favorable opinion when a business leader receives an award for best CEO or Entrepreneur? What about when a company receives an award for corporate governance, innovation or great place to work? We assume the selection was unbiased and evaluation criteria were stringent. Hence, we form a positive image of the winner. Nothing succeeds like success.

Now what happens when we discover that the leaders whom we have put on a pulpit have feet of clay? Recently, a Miami businessman, Mr Claudio Osorio, former president of Inno Vida Holdings was arrested for a $40 million fraud. In 1997, Ernst & Young had awarded Mr Osorio “Entrepreneur of the Year” title for CHS Electronics, a company he owned. Amazingly, in 1999 CHS Electronics settled a class action lawsuit brought by its shareholders. The next year the company became bankrupt. Doesn’t this raise questions on jury’s decision and selection criteria for giving the award?

Closure home, the story is the same. Ramalinga Raju, previously the CEO of Satyam responsible for conducting the biggest corporate fraud in India, was awarded Ernst & Young Entrepreneur of the Year Services Award in 1999 & 2007 (which was withdrawn later). Other awards received by him were – Dataquest IT Man of the Year Award 2000, CNBC’s Asian Business Leader – Corporate Citizen of the Year award in 2002 and Golden Peacock Award for Corporate Governance 2008 (withdrawn later).

According to my understanding, the Indian scene for corporate leadership awards is quite easy to understand. There is a group of 25 prominent business leaders from whom the 6-7 jury members are selected. During the year, in the 5-6 corporate award functions at least 2-3 jury members are common. The same group of 50 companies receive the awards year on year. Each function distributes 9-10 awards. Around 7-8 awards are given to this group and just a couple of new names are added. In the newspapers, a detailed write-up is given of the jury interactions for selecting the awardees.

One might say that these are the top performing companies and CEOs; hence, they deserve the awards.  The other could be that these CEOs have excellent public relations teams working to get the business leaders and companies nominate. However, in my cynical view it appears as a game of corporate musical chairs where business leaders pat each other on the back and allow entry to a few in the exclusive club. I am not joking; a recent award function separated the members of the exclusive club from the non-exclusive business leaders by demarcating the area with a red rope.

Giving an award may not be big deal. However, it becomes serious when awards of corporate governance excellence or best entrepreneurs are given. People assume that after being evaluated by peers and benchmarked against best practices, these leaders and companies are best in the pack. A small individual investor relies on this information when making an investment decision. Can we count the number of investors who traded in Satyam shares believing it to be an excellent company? These investors lose money and sometimes their whole savings. Hence, the ethics and integrity of these awards must be maintained at all cost.

The corporate award functions should not become similar to the Bollywood award functions. The common perception of Bollywood awards is that whichever hero or heroine performs on the award function gets an award. Just a few awards are given on actual box office performance. I don’t have any information of behind the scene activities of corporate award functions. However, investors will lose faith if the Bollywood method is followed.

Closing thoughts

In my view a government body, something like SEBI should evaluate the criteria of the bodies giving awards. It shouldn’t become a brand building and sales exercise to get clients and investors. Hence, only a few select organizations should be allowed to distribute awards. Periodically, the government body should conduct a review. Moreover, the government body should evaluate the cases of awards given incorrectly and recommend legal action where required. What do you think?

5 Things CFOs Should Do In Planning Process

In December, senior management focuses on formulating strategies. Department heads prepare business plans and budgets. Risk management departments define the next year’s agenda and plans. Everyone works hard at planning and preparing for the coming year. However, most of the efforts are in vain and result in failure. The problem is that generally people do these activities independently and make no attempt to align them. The ideal integrated sequence is below.

strategy

However, this does not happen. For instance, department heads do capital expenditures while ignoring the strategy. Business teams define performance indicators and risk managers establish risk indicators, without syncing the two indicators. Situations occur where desired performance is achieved at very high-risk levels. Business teams ignore the risk levels until disaster occurs. With the multitude of unsynchronized management information, boards make incorrect decisions with information overload. Hence, at the end of the year only a few organizations can claim that they achieved the strategy and targets.

The Chief Financial Officers (CFOs) can play a pivotal role in bringing the different facets together. CFOs sit on the board and participate in the strategy formation process. Department heads submit their plans and budgets to CFOs for review and consolidation. Generally, Chief Audit Executives (CAE) administrative reporting is to the CFO. Quite frequently, CFOs act as defacto Chief Risk Officers (CRO). Hence, CFOs can put the jigsaw puzzle together. The key things they need to look into to revamp the process are as follows:

 1.     Strategy Formulation

 The common misperception is that organizations have a proper strategy formation process. In reality, the ideas supported by the CEO and politically strong CXOs are adopted without much constructive discussion since no one wishes to rock the boat. Secondly, a formal strategy process is not in place in most organizations. Moreover, at the time of strategy formation upside and downside risks remain unidentified, as CXOs do not invite CRO to the discussion. The CFOs can influence the other CXOs to implement a formal strategy development process and conduct a strategic risk assessment in each phase of strategy formation.

2.     Business Plans

While strategies are for 3-5 year period, business plans are drawn annually. However, the changing business landscape makes business plans redundant on formation. Reason being that business plans are prepared on a set of assumptions on customer behavior  engagement and market situation. Real interaction with customers and entry into the market prove most of the assumptions incorrect. Additionally, department heads make independent business plans to show one up man ship. Hence, performance objectives are missed and risks remain unidentified. The need of the hour is for businesses to react fast and give cohesive messages in response to market changes. Therefore, CFOs must make the business planning process dynamic and integrated.

3.     Budgets

More than 60% of the organizations are unsatisfied with their ability to link strategy to operating budgets. Additionally, organizations spend 4 to 6 months in preparing budgets with numerous iterations back and forth between departments. Meanwhile the business plans change due to the volatility in the market. Hence, organizations are feeling the need of speed in the budgeting and forecasting process. CFOs must adopt rolling forecasts rather than static budgets to improve planning and control. Rather than doing post facto variance analysis they can collaborate with business teams to give real-time analysis.

4.     Performance Indicators

Performance indicators measure the reward side of the strategy. Without the risk indicators, they give an incomplete picture of business status. Another aspect is that performance indicators and risk indicators for the same strategy or plan are not aligned together and are reported at different periods. Organizations sometimes continue to measure redundant parts and do not update the indicators with change in strategy and objectives. A prime example is the financial crises. A few banks achieved performance targets without understanding the risk levels. Hence, CFOs must use technology to create relevant dashboards to monitor indicators to keep a firm grasp on the business.

5.     Risk Indicators

 Risk managers fail to address the twin shortcomings in process of identifying key risk indicators. Firstly, risk managers do not ascertain strategic risk indicators. Secondly, a lot of meaningless indicators are created which do not really find out the overall business risks. Hence, CXOs fail to separate the noise from the inflection points. Moreover, Nassim Taleb’s point of view that most significant risks are unpredictable needs to be thought over. There might be too much data available and organizations might look at risk indicators they are comfortable with, until the bubble bursts. CFOs can identify key risk indicators for strategy and business plans, and synchronize them to performance indicators. That will close the loop and move the business in the right direction.

Closing Thoughts

Synchronizing multiple factors between strategy and indicators influences a company’s capacity to achieve goals. With predictions of recession and volatile business environment, dropping the ball is highly probable. Understanding which economic predictions to rely on, which market trends will impact long-term and what are the strategic inflection points, spells the difference between success and failure. Hence, CFOs must play the vital role of coordinating and aligning various steps between strategy formation and identifying indicators.

Bharti Walmart India – Internal FCPA Investigation – Part II

The previous post raised more questions than gave answers. In light of the on-going investigation, it is difficult to predict results. However, I looked at the recently released FCPA Resource Guide to the U.S. Foreign Corrupt Practices Act by the Criminal Division of the U.S. Department of Justice and the Enforcement Division of the U.S. Securities and Exchange Commission. It sets some clear guidelines and mentions earlier cases with similar issues. It is a good read for Indian managers working in multinationals dealing with FCPA compliance requirements. I am sharing below some insights about the implications of the case.

1.      Liability of Indian Employees

As per reports, the CFO and the legal team were suspended during the course of the investigation. If the US Department of Justice decides to pursue a criminal case, these employees can be prosecuted.

Interestingly enough, the Indian managers consider their capability to bribe various government officials to get a job done as strength. One often hears them saying – “Oh, I have a contact; s/he will do the job for X amount of money. Don’t worry about the legal provisions, they can be circumvented.” Since one rarely hears any action being taken by regulators on the provisions of Prevention of Corruption Act of India, hardly anyone hesitates to take or accept a bribe.

However, Indian employees working in multinationals have to think twice about paying a bribe to get a job done. The FCPA guidelines are strict. It states – “The FCPA’s anti-bribery provisions can apply to conduct both inside and outside the United States. Issuers and domestic concerns—as well as their officers, directors, employees, agents, or stockholders—may be prosecuted for using the U.S. mails or any means or instrumentality of interstate commerce in furtherance of a corrupt payment to a foreign official.” Hence, even sending mails to US boss or colleague that involves a discussion of a bribe payment can make an Indian employee liable. Considering the provisions, the best policy for Indian employees is to keep their hands clean and follow the legal process diligently.

Another aspect to note is that a bribe does not need to be paid to hold an employee liable. The guidance note says – “Also, as long as the offer, promise, authorization, or payment is made corruptly, the actor need not know the identity of the recipient; the attempt is sufficient. Thus, an executive who authorizes others to pay “whoever you need to” in a foreign government to obtain a contract has violated the FCPA—even if no bribe is ultimately offered or paid.” Hence, Indian management and employees both can be prosecuted on this basis.

2.      Challenges for Licenses

With the opening of the retail sector, multinationals need to obtain various licenses to operate in India. The challenge is getting the licenses according to their business strategy and plan.

For instance, IKEA recently obtained from Foreign Investment Promotion Board (FIPB) to invest euros 1.5 billion to open 25 stores in India. However, IKEA was granted permission to open single brand stores for furniture only. It was denied permission to sell textiles, office supplies, food and drinks.

Now the question is, under these circumstances what options will the foreign investor consider? Will they agree to sell products according to permission? The permissions maybe denied for the most profitable lines of products. It may not make sense to sell products with low margins. Hence, they will have the difficult choice of either not entering the Indian market or attempt to influence the government agencies to grant permissions for selling other products. If the second option is chosen, there is a high probability of bribes being paid. More so, since Indian government officials know what will hurt the business venture of the foreign company, they might use denial tactics to coerce the organization into paying bribes. Hence, it is a vicious circle.

A LinkedIn member gave a useful suggestion to curb bribes in the licensing process. Rangarajan Gopalan, Investigator US Department of Homeland Securities in New Delhi,  suggested a single window concept for obtaining licenses in retail industry. If government implements the suggestion, the retail companies will not have to run around 32 different agencies to get licenses.

3.      Partner Liabilities  

In the event of the holding-subsidiary relationship or joint venture partnership, the Indian company can be charged jointly and/or separately.

The guidance note illustrated the implications with a previous case. For instance, “a four-company joint venture used two agents—a British lawyer and a Japanese trading company—to bribe Nigerian government officials in order to win a series of liquefied natural gas construction projects. Together, the four multi-national corporations and the Japanese trading company paid a combined $1.7 billion in civil and criminal sanctions for their decade-long bribery scheme. In addition, the subsidiary of one of the companies pleaded guilty and a number of individuals, including the British lawyer and the former CEO of one of the companies’ subsidiaries, received significant prison terms.”

Hence, if the US company is ignorant of the bribes being paid by Indian employees to conduct business, the Indian employees can face criminal charges and the Indian organization may have to pay hefty fines.

Closing Thoughts

The Indian organizations need to assess their FCPA compliance level and not take the issue lightly. The repercussions of ignoring the issue are huge. The legal and reputation risks can put the company to a great disadvantage. Moreover, the employees must follow the legal process rather than find ways to circumvent it.

 References: 

  1. FCPA Resource Guide to the U.S. Foreign Corrupt Practices Act by the Criminal Division of the U.S. Department of Justice and the Enforcement Division of the U.S. Securities and Exchange Commission.
  2. FIPB clears IKEA retail store plan

Bharti Walmart India – Internal FCPA Investigation – Part I

Walmart after the Mexico US Foreign Corrupt Practices Act investigation identified India operations as a high risk. It commenced an internal investigation with the help of KPMG India and law firm Greenberg Traurig. Recently CFO and five officers of legal team were suspended. The legal team’s job entailed procuring licenses required for stores and other real estate approvals, taxation etc. Bharti Walmart has opened 18 stores till date. Hence, the suspicion is that these officers paid bribes to get the licenses.

According to the Economic Times article, multiple government permissions are required from the government. The Retail Association of India lists 51 different approvals from 32 different agencies. Seeing the corruption index of India and the way government departments’ function, I would be very surprised if an organization manages to obtain all the relevant licenses without any grease payments. Hence, the question is how will the organizations manage to function without paying bribes?

1.      Dubious Dealings

Considering the huge operations of Bharti group, I would be very surprised if the bribes were paid without senior management approval. Most of the liaisons work has senior managers’ tacit or explicit approval. Therefore, is it right to suspend some after obtaining licenses. What happens in such a case to the license? Will the license be revoked, cancelled, or returned? If not, what is stopping the organizations from first taking the licenses by paying bribes and then doing a clean-up exercise to show their commitment to ethics?

2.      Joint Venture Liabilities

The second issue that crops up is the working of the joint venture in such circumstances.  Let us assume the investigation reveals bribes were paid. In such a situation, will Bharti group be expected to pay back the bribe money? Secondly, if the US authorities under a civil case fine Walmart for FCPA contravention, will Bharti be expected to pay the fine. Seeing the trend the fine could be huge and would wipe out profitability of the company. Moreover, US Department of Justice can pursue criminal liabilities. Then will the Indian officers be implicated for the same.

3.      Foreign Direct Investment (FDI) in Retail Industry

The government has recently allowed FDI in retail industry. The challenge is that in India, most of the retail operations operate by paying bribes at different levels. Hence, a foreign investor will not get a level playing field as the anti-corruption laws of their country bind them. The situation is serious. For instance, the next stage after obtaining licenses would require importing goods.  The FCPA strictly prohibits paying bribes to custom officers whereas in India this is a common business practice. Can an organization wait for months to get its stock cleared by the custom officers? Now the foreign investors will analyse the reward versus risk scenario of their business plans for investing in retail industry in India.

Closing Thoughts

The case opens up interesting aspects of risks of doing business in India. Corruption poses serious obstacles in doing fair business dealings. The FCPA and laws of various countries strictly prohibit paying bribes to foreign officials. The US government has followed some stringent measures against companies contravening the laws. Under such circumstances will the joint ventures between foreign investors and Indian counterparts work?  India cannot change overnight, so what is the solution? Share your thoughts with me on this.

References:

Bharti Walmart suspends CFO, legal team due to FCPA bribery probe

Auditor’s Communication With Audit Committee

Finally, the US audit committees will be getting the full picture of the financial statements from the auditors. The Public Company Accounting Oversight Board (“PCAOB” or the “Board”) of US  is adopting Auditing Standard No. 16 – Communications with Audit Committees. It is aimed at improving dialogue between auditors and audit committees to enable better oversight and financial reporting.

The scope of communications has increased from the previous practice of discussing – accounting policies, procedures and estimates, quality of financial reporting, unusual transactions and significant auditing and accounting matters. It covers a  more matters that will increase clarity.

Previously the status of communication was aptly described by George Bernard Shaw’s quote – “The single biggest problem in communication is the illusion that it has taken place.” Audit committees in my view lacked critical information . Secondly, as there is a shortage of financial experts (just one is mandatory) they were in no position to analyse the details of the financial statements. It was easy to hide artistic accounting from them. This standard will reduce communication gap between the auditors and audit committee.

In India, though the roles and responsibilities of the auditor and audit committee are defined in the Listing Agreement of SEBI and New Companies Bill, the nature, content and quality of communication is not specified. It mandates audit committee should meet at least four times a year, however doesn’t shed light on the quality of discussion to take place. The audit committees in India, are required to look into loan transactions, related party transactions and a couple of other things. These requirements are not mentioned in the list below.

In brief, as per Auditing Standard No. 16 the auditor would be required to communicate the following to the audit committee:

a.  The terms of appointment and engagement, objective of the audit, and responsibilities of management and auditor.

b. An overview of the overall audit strategy, including timing of the audit, significant risks the auditor identified including risk assessment procedures, and significant changes to the planned audit strategy or identified risks;

c. Information about the nature and extent of specialized skill or knowledge needed in the audit, the extent of the planned use of internal auditors, company personnel or other third parties, and other independent public accounting firms, or other persons not employed by the auditor that are involved in the audit;

d. The basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors;

e. Significant accounting policies and practices including changes. Reasons certain policies and procedures were considered critical and the effect on them in respect to current and future events. Effect of policies and disclosures in controversial area and where there is lack of authoritative guidance.

f. Situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting;

g. Description of process for developing critical accounting estimates including the significant assumptions. If any significant changes are made in the process or estimates.

h. Significant unusual transactions with policy and procedures used by management for accounting unusual transaction;

i. Quality of financial reporting including whether auditor identified bias in management’s judgement about the amounts and disclosures in financial statements. Assessment and conclusion of critical accounting policies. Auditor’s understanding of the business rationale for significant unusual transactions.

j. The results of auditor’s evaluation about financial statement presentation. Whether the reporting including form, content and arrangement are in conformity to standards.

k. Difficult or contentious matters for which auditors consulted external consultants

l. Auditor is aware management consulted external sources, the auditors should also give their opinion;

m. The auditor’s evaluation of going concern;

n. Uncorrected and corrected mis-statements including those discussed with management;

o. Material written communication with management

p. Disagreements with the management

q. Departure from the auditor’s standard report;

r. Difficulties encountered in performing the audit, and

s. Other matters arising from the audit that are significant to the oversight of the company¡¦s financial reporting process, including complaints or concerns regarding accounting or auditing matters.

Closing thoughts

The various auditing and accounting standards in India cover most of the points mentioned above. The auditor is required to ensure conformity to the standards and comment on the same if there are variances. However, there is no specific guideline for communication between auditor and audit committee. As the US standard just defines minimum communication requirements it would be beneficial to formulate and adopt a similar one in India and other countries. It will ensure a specific level of interaction with auditor and audit committee is maintained and the audit committee makes informed decisions.

What do you say? Should there be a global standard for communication with audit committees? What other steps can be taken to reduce barriers to communication between the auditor and audit committees?

References:

PCAOB Adopts Auditing Standard No. 16, Communications with Audit Committees, and Amendments to other PCAOB Standards

 

Performance of Indian Boards

The board of directors have the responsibility for steering the organization in the right direction and guiding the CEO and senior management. However, worldwide they are lambasted for catering to the manifested interest of CEO and senior management at the expense of shareholder interest. The criticism is that boards’ failure to maintain independence results in  under-performance.

A prime example is the decision of Satyam board to acquire Matyas. The board approved a deal of USD 1.6 billion to acquire Maytas Infra for USD 300 million and Maytas Properties for USD 1.3 billion. Ramilanga Raju after admitting the Satyam fraud stated that deal was to fill Satyam with real assets instead of fictitious assets. The scandal came out as shareholders refused to approve the deal and Raju didn’t have a way to cover the fraud. The recent case of  Kingfisher Airlines debacle clearly shows that the board was not asking the right questions.

Mr. N. R. Narayan Murthy, founder of Infosys, in his book “A Better India, a Better World” succinctly describes the prevailing trends. He wrote – “A a result, the 1990s was the era of the stock-option-fattened, superman-superwoman CEOs who could do no wrong in the eyes of their admiration-heavy boards, and who were seen as demigods. Lax oversight by the boards made these CEOS more or less omnipotent.” He has lead corporate governance in India by walking the talk and his scathing comments are right on target. He has given a number of suggestions to improve corporate governance and board performance.

Let us see, whether Indian boards are up to the task. To analyse the performance of the boards, I have taken the best practices of the board from the report of Trinity Group and Mr. Narayan Murthy’s book. The statistics are from  India Board Governance report 2011 and the relevant laws are from the New Companies Bill 2011.

1. Constitution of the board

Corporate governance practices mention ideal board size of 8-12 members with around one-third to half the members being non-executive and independent directors.  Indian boards on an average had 9.6 directors of which 5.2 were independent directors in 2010 and 60% of the boards have separate roles for CEO and Chairpersons. On the whole, this sounds good, however, in light of the additional information given below, the perspective changes.

a)    In 2010 in India, board chairpersons were members of 9.5 external boards though majority of the memberships were of private companies. According to the survey “the maximum public board memberships held by an individual was 12, and the maximum private board memberships a whopping 37″.

b)   The CEOs & managing directors were on an average board members of 7 external boards. “The highest number of public company board memberships held by a CEO was 10, whereas it was 32 for private company boards.”

c) Non-executive directors, on an average held a total of 6.7 total board memberships, with 2.1 public and 4.6 private memberships.

d) 56% of the directors surveyed identified the limited talent pool as an impediment, with 38% perceiving it as a major hindrance. Yet, less than 10% used search firms or other 3rd party sources to locate suitable talent.


The lack of experienced and trained directors is the key reason for a few directors available in the talent pool holding multiple memberships. When most independent directors are selected from the social circle of the CEO or Chairperson, there are very few who would not toe the line stated by the CEO. With the multiple holdings, a conflict in one board may impact the relationship in another board. Hence, instead of independence, diplomacy and self-interest prevails.

Mr. Murthy candidly mentions that “board independence from management continues to be affected by directors who have limited accountability to shareholders and are ill-equipped in exercising management oversight.” He stated that in Infosys, directors are given training and a job charter to ensure that they fulfill there responsibilities appropriately.

2) Strategy review by the board

According to the best practices given in the Trinity report, “the board’s primary responsibilities include : (a) reaching agreement on a strategy and risk appetite with management, (b) choosing a CEO capable of  executing the strategy, (c) ensuring a high-quality leadership team is in place, (d) obtaining reasonable assurance of compliance with regulatory, legal, and ethical rules and guidelines and that appropriate and necessary risk control processes are in place, (e) ensuring all stakeholder interests are appropriately represented and considered, and (f) providing advice and support to management based on experience, expertise, and relationships.”

On the other hand, the Companies Bill mentions the board’s power as: “ (a) to make calls on shareholders in respect of money unpaid on their shares; (b) to authorise buy-back of securities under section 68; (c) to issue securities, including debentures, whether in or outside India; (d) to borrow monies; (e) to invest the funds of the company; (f) to grant loans or give guarantee or provide security in respect of loans; (g) to approve financial statement and the Board’s report; (h) to diversify the business of the company; (i) to approve amalgamation, merger or reconstruction; (j) to take over a company or acquire a controlling or substantial stake in another company; (k) any other matter which may be prescribed

The theoretical legal powers given are quite different from the actual working of an effective board. On an average in India in 2010, board members met 6.5 times during the year. The minimum number of meetings were four, that is a statutory requirement and maximum were 19 board meetings by a company. The boards met on an average three times during the year for strategic and business review.

Considering the number of meetings conducted by the board, with the legal responsibilities and practical requirements, it is not feasible for the boards to do a constructive strategic review of the business or provide regulatory oversight. Too big a mandate has been given, while the time spent on it is relatively small. It is not surprising that most boards are acting as rubber stamps to the senior management plans. It is a case of imbalance between power, responsibility and time commitment.

3. Focus on risks

After the Satyam scandal and financial crises, the board focus on risk management has increased. The boards ideally need to determine the risk appetite, review internal audit reports and external auditors reports, understand various strategic, financial and operational risks, and maintain compliance oversight.  In India, the Company Bill mandates an audit committee for listed companies, with majority being financially literate independent directors.

In 2010, in India, 69% of the board members respondents stated that boards are considering risks as top priority. However, 31% mentioned that boards are not involved in systematically addressing corporate risk management.

My view is that the focus on Indian boards is more on risk of misreporting financial statements rather than others. Risk management field as such is still in young stage in India, and board members are ill-geared or untrained on the various aspects.

4. Information availability

The decision-making of the board is subject to the information available with it. As per law, board members are ideally required to receive all relevant information about board resolutions and decisions, seven days before the meeting. However, board members responded that most of the documents are given prior to the meeting or just a couple of days in advance.

Moreover, “a vast majority of boards depend largely on management reports (90%) and informal management discussions (79%) for business information. Third party reports and stakeholder views are used as tools only by 23% of the companies.”

With such limited information, and high dependability on company sources, the directors may not be in a position to make informed decisions. The directors don’t even have sufficient time to study the presented information to make independent decisions and cross question the senior managers. Hence, this could be a key reason for poor performance.

5. Performance Review of CEO & senior management

The compensation committees recommend the CEO and other senior managers. In India, around 80% the respondent companies had a compensation or remuneration committee. The issue of CEO compensation isn’t as big as the western world, however, it is fast gaining prominence. Some high earning CEOs in the top 100 list are being evaluated on the basis of returns to investors.

The board as such has to evaluate  CEOs performance. In the west, the “star” CEOs are in the limelight and are paid high salaries in relationship long-term company performance. However, India scenario is different. Most of the critical positions in family organizations are held by family members and relatives. In such a scenario, the board or compensation committee are hardly in a position to evaluate the performance or recommend salary.

6. Performance review of board

As per law, the nomination committee reviews directors performance , and recommends removal. However, two-thirds of the independent directors stated the roles and responsibilities of non-executive directors are not defined clearly. Hence, without the clarity in role, the evaluations can hardly be constructive.

As such, the boards in India have the following three priorities: “ensuring overall corporate and statutory compliance (90%), monitoring business and operating performance (87%), and establishing and monitoring financial standards and internal controls (82%). Leadership development, succession planning, CSR and risk management continue to be low on the board priority list.”

The professionally run organization do claim for independent evaluation. For instance, Tata  and Infosys succession, the nomination committees were said to be doing independent evaluation. However, in both cases, questions were raised on the final selection. Though Mr. Murthy in his book mentioned that – “At Infosys, the chairman of the board sits with each board member, discusses his/her evaluation, and suggests remedies and course-corrections. The chairman’s performance review is handled by the lead independent director.

In my opinion, the practice of evaluating board performance only exists in some companies in India.

Closing thoughts

Unless the mindset changes to compassionate capitalism where business is done with integrity, decency and in a principled manner, boards will continue to be tutorial heads without much power and say. To ensure boards perform better, shareholders and investors need to become more active. The regulators need to ensure governance codes are followed in spirit and not just tick box mentality. A more elaborate role can be defined by regulators with mandatory requirement of time commitment and reporting requirements.

References:


An Update of Adidas India Euro 125 Million Fraud Story

In the last couple of weeks, some startling information was revealed by the media about the fraud. To recap, Adidas global management disclosed euro 125 million (Rs 870 crore, USD 157.68 million) fraud in India operations in the first quarter end report of 2012. Subsequently, Adidas India management filed a police complaint against the ex-CEO Subhinder Prem Singh and ex-COO Vishnu Bhagat. Now the battle lines are drawn and allegations are flying. Here are some surprising revelations of the case so far.

Adidas management is alleging “commercial irregularities” and mismanagement of Reebok operations for last five years. Reebok and Adidas India operations were merged under Mr. Singh last year. Mr. Singh portrayed it that the allegations are more about a power struggle between the two groups and Adidas India operations has similar number of unreported frauds, as mentioned in the earlier post.

Some financial numbers and other details that were reported by the media are:

1) Profitability of Adidas & Reebok India

An Economic Times article stated that Reebok India March 2010 reported Rs 786.1 crore (USD 142 million) total income with a loss of Rs 40 lakhs (USD 72,000) . On the other hand, Adidas India operations showed a profit of Rs 455.6 crore (USD 82.75 million) for the year ending March 2010, with a profit after tax of Rs 9.01 crore (Rs 1.63 million). Mr. Singh attributed the difference to two aspects. First, Reebok India had a share capital of Rs 23 crore (USD 4.16 million) in comparison to Adidas India’s share capital of Rs 99 crore (USD 17.94 million), hence has to pay interest on borrowed funds. Second, Reebok India paid a royalty of 5% on sales, that amounted to Rs 110 crore ( USD 19.93 million), whereas Adidas India isn’t required to pay royalty. Hence, Mr. Singh’s contention is that Reebok India  performed better than Adidas India.

This practice of charging royalty to one arm of the company and not the other in the same country, is somewhat controversial. It raises questions on the transfer pricing practices followed by the company.  The Income Tax department may view it as an intentional strategy to deflate profits to avoid taxation.

Subsequent to the story breaking, the Income Tax department has commenced an inquiry and issued notices to executives for probing financial wrong-doing in last four years to determine tax evasion.

2) Police Complaint

The FIR, which has been seen by Bloomberg UTV says that: 

- Irregularities include over-invoicing to the tune of Rs 147 crore (USD 26.64 million)
- Running a false franchisee referral programme, receipts from which were about Rs 114 crore (USD 20.66 million)
- Maintaining four secret warehouses where company goods were diverted, all of which have been sealed and goods confiscated
- Raising fake invoices of about Rs 98 crore (USD 17.76 million) to show higher sales and claim promotions, bonus and incentives
- And collusion with some customers to aid the two officers in the scam”

Behind the allegations, the details when pieced together give the following story.

According to the Economic Times story, Mr. Singh started gunning for the top job of the merged entity from 2008, knowing that merger was inevitable. He pursued expansion plans to show numbers and beat internal competition, at the expense of profitability.

The source of the problems appears to be the minimum guarantee strategy adopted for store franchises.  Reebok had 100 stores in 2003, and grew to 800 stores. As per the minimum guarantee program, the franchisee was given a specific sum, irrespective whether the company earned any money from the store. Small time business persons were invited by Reebok to open stores and these stores didn’t make any money. Hence, the costs ran high, with no revenues. Rumors are that some money was earned by Mr. Singh privately for opening these stores.

Another information shared by police is that Adidas management claim that Mr. Singh and Mr. Bhagat diverted stock to four secret warehouses near Delhi doesn’t hold much water as no stocks were found in the warehouses. Adidas India claims to have confiscated goods worth Rs 63 crores (USD 11.41 million) from these warehouses. According to the police, three of the four warehouses were empty, and the fourth the new management has taken the goods.

However, from the information available so far, it appears that sales figures may have been inflated, and closing stock deflated to show higher profitability and meet the growth targets. It is possible, that false sales invoices were created and the goods transferred to the warehouses. There are allegations from store owners also that there are discrepancies between statement of accounts. The debit and credit balances significantly differ. Hence, the sale invoices may have been made in the franchises name without an actual sale. If this is true, most of the internal controls were over ridden by management.

Another aspect reported was that German management at headquarters was aware of the complaints and various issues cropping up, however chose to ignore the same due the great performance being shown. They apparently didn’t take proper action on the auditors report also. Of course, there are likely to be questions raised as to quality of work done external and internal auditors.

With all the information available till date, the fraud figures don’t add up to Rs 870 crore (USD 157.68 million). The police investigators are stating that beside the complaint, no evidence has been provided by Adidas management till date. Reading the corporate boxing match, Registrar of Companies under Ministry of Corporate Affairs has commenced an investigation.

Closing Thoughts

With all the dirty linen being washed in public domain by Adidas group, it has attracted regulators attention. If the plan was to browbeat Mr. Singh, without adequate evidence the prosecution will fail. If in reality all the allegations can be proved, then Mr. Singh along with a number of senior executives are in hot soup. Till date it is the largest fraud case reported by a multinational company in India. Let us wait and watch to get some more juicy information.

References:

  1. How Adidas Slipped in India – Economic Times
  2. Reebok under tax lens, Adidas seizes goods from warehouses
  3. The Reebok Adidas scam – another corporate saga in courts

Reflections on New Companies Bill Auditor Rotation Clauses

The New Companies Bill 2011, tabled at the Parliament proposes a few clauses on auditor rotation. According to the new provisions, an auditor will be appointed in the first annual general meeting for a five-year term. Thereafter, the auditor will be changed as per the members’ decisions.

An additional clause for listed companies states that the same individual auditor cannot be appointed for a term exceeding five consecutive years. Secondly, an audit firm cannot be re-appointed for more than two five-year terms. For re-appointment purposes for the individual auditor or audit firm, there has to be a gap of five years. Moreover, for appointment or re-appointment purposes, there should be no common partners between the new firm and old audit firm.

Another interesting clause is that members can resolve to ask the audit firm to rotate the audit partner and team every year.

These clauses will ensure that auditors rotate every five years in the listed companies. As investor confidence is based on independent reporting of the auditors, the thought behind these clauses is that rotation of auditors will ensure independent reporting. The move is good, as economic growth is dependent on investor confidence in financial reporting. These clauses were incorporated in the draft after the Satyam fiasco. However, rotation isn’t a silver bullet that will resolve all auditor independence issues. A few concerns about the clauses are listed below:

1. Appointment of auditors for listed multinational companies.

Similar auditor rotation provision do not exist in other countries. In US, PCAOB recently held discussions on auditor rotation and independence. The general opinion of US auditors was that rotation does not ensure independence and comes with a huge financial cost. Hence, the question comes up whether multinational companies will be open to having different auditors in India, than in their headquarters. For large organizations, consolidation of accounts from different locations is a huge task, and with different auditors the information flow and audit practices may differ. Hence, the head office auditor may find it difficult to rely on the work of a local auditor.

Multinational companies are generally comfortable with big four, hence the audit will continue to rotate between big four. Very few Indian companies have the skill set and bandwidth to audit large multinationals. Therefore, this clause will put some practical challenges for multinational listed companies.

2. Audit firms’ partnerships

Indian audit firms scenario is unique in a way, as Institute of Chartered Accountants of India prohibits foreign audit firms to practice in their own name. Pricewaterhouse is the only one allowed, since it entered the market before these guidelines were passed. Others, for instance, Ernst & Young Indian member firm is S.R.Batliboi and company, and all audits are performed in Indian firm’s name, though partnerships are common. The provision of not having common partners applies in this scenario, as some audit firms are auditing under multiple names. PWC audits under the names of PW and Lovelock & Lewis.

The challenge in this clause is that audit partners move among the group companies. Some firms have organized the partnerships in a way to avoid common partnerships, however work under the same management. It will be a difficult task for companies to identify linkages between various audit firm partnerships. The onus should ideally rest with the audit firm to ensure that there are no common partners.

Another interesting aspect is  audit partners movement among big 4 and other companies. If an audit firm is pursuing an appointment, they now will have to be careful that another firms audit partner is not recruited in their partnership at the same time. This might again result in some fancy footwork to avoid the loss of a client.

3. Independence of the retiring auditor

According to the provisions, audit firm will mandatory be changed after two consecutive five-year terms. In simple words, ten years is maximum period an audit firm can audit a client on a single stretch. Hence, the audit firm knows that it is going to lose the audit client, however, the option to provide non-audit related services opens up. Law prohibits auditors from providing the following services to audit clients:

(a) accounting and book-keeping services;
(b) internal audit;
(c) design and implementation of any financial information system;
(d) actuarial services;
(e) investment advisory services;
(f) investment banking services;
(g) rendering of outsourced financial services;
(h) management services; and
(i) any other kind of services as may be prescribed

These services generally are more lucrative than the audit fees earned. Hence, a retiring auditor may wish to keep good client relationships to obtain future assignments. In such a scenario, one has to view rotation benefit skeptically, as the audit firm may not maintain independent reporting  as desired. Rotation of auditors in such a case may just result in adherence to legal requirement instead of contributing to auditor independence. As such, old Indian business houses have 2-3 audit firms that they use interchangeably in various subsidiaries for audit and other services. The work would just get shared among them.

4. Selection of new audit firm

As mentioned earlier, selecting a new audit firm will be difficult for large organizations. Reason being, besides big four there are just a handful of Indian audit firms who have the capability of conducting audits of multinational organizations. A few of these would already be providing some consulting services to the audit client, hence would not be eligible for appointment as auditors. If the potential of earning from consulting services is more, they might not drop those assignments in favor of audit.

Next aspect is that the provisions have additional clauses for barring a person from becoming an auditor. These relate to the usual clauses of individual, partner or his relative not having in holding or subsidiary companies – securities, directorships, loans, business relationships, managerial positions, or any other conflict of interest.

These clauses result in audit firms and client doing a lot of leg work to ensure that all legal requirements are met. All these aspects limit the choice of selection of new auditor to 3-4 audit firms. Since the audit business is going to circulate among the same set of audit firms, it is doubtful that mere auditor rotation would result in better financial reporting.

Closing thoughts

Auditor independence is a complex subject as it forms the bedrock of investor confidence in financial reporting.  Auditor rotation is a good step to ensure that auditors do not lose their professional skepticism and independence by doing the same audit for decades. However, additional quality monitoring procedures of audit firms and review procedures of financial reports need to be built in the regulatory system in India. India lacks a few aspects of US and other developed countries in this matter, however, that is a discussion for another post. On a positive note, the rotation clauses give an opportunity for medium-sized Indian audit firms to build skill sets to pitch in for business of large organizations.

Risk Management Failures in Kingfisher Airlines

Mr.Mallya with KFA Air hostesses

The king of good times is facing hard times. Launched in 2006, with much fanfare by its Chairman, Mr. Vijay Mallya, Kingfisher Airlines (KFA) is presently in dire financial straits. After the euphoria abated, KFA’s strategy, performance and financial health has been questioned from mid-2008. Now the company is facing major financial and operational problems. The press statement from KFA, on 12 March 2012, highlights the challenges:

“The flight loads have reduced because of our limited distribution ability caused by IATA suspension. We are therefore combining some of our flights. Also, some of the flights are being cancelled as a result of employee agitation on account of delayed salaries. This situation has arisen as a consequence of our bank accounts having been frozen by the tax authorities. We are making all possible efforts to remedy this temporary situation.” 

KFA is a good case to understand the impact of failure in risk management. The management ignored the warning signs of stormy weather and failed to navigate the company into safety.With hindsight, some of the important decisions made by the airline appear incorrect. Let us analyse the  top 5 risks.

1. Strategic Risk – Market Analysis 

 KFA was launched as a premium business class airline. That was the first mistake, a lack of understanding of customer requirements and basing a decision that luxury sells in airlines. Organizations focus on reducing costs and  usually just CXOs are allowed business class travel. Rest of the staff mostly travels by economy class. Moreover, buying most expensive business class tickets doesn’t go down well when seniors aim to project the image of walking the talk.

Even consultants, whose travel tickets are paid for by clients, hesitate to book KFA tickets. It appears that they are abusing privileges. Hence, the market size for business class tickets is small in India.

Secondly, internationally Southwest Airlines operating model has proven successful. It is a low-cost airlines, provides minimum frills to customers at reasonable rates. Mr. Mallya, highly successful in liquor business, didn’t comprehend the differences in customer preferences within the two industries. Customers may buy expensive alcohol, but not airline tickets, since the total cash outflow  is higher.  It is a price sensitive market. Therefore, KFA adopted an incorrect strategy from the start as it failed to understand the market dynamics.

2. Strategic Risk – Merger with Air Deccan 

KFA acquired Air Deccan, a low-cost airline in 2007. Five years of operations is a key criteria for an airline to fly internationally. Hence, KFA acquired Air Deccan’s international flying rights and simultaneously entered the cheaper market segment.  It made the following announcement in September 2008 financial results commentary:

The merger of the two operating airlines into one corporate entity has also enabled savings on operating costs such as Engineering and Ground Handling, Insurance and Catering. Employee costs have also been addressed through an integrated organization which enabled the Company to terminate the contracts of most expatriate staff and impose a hiring freeze on new appointments.

After the merger, first signs of trouble cropped up. As per a Business Today article, it became the largest Indian airline with 27.5% market share, and domestic travel increased by 30%, however it didn’t make profits. Despite the fact the its main rival – Jet Airways – continuously showed profitable quarters.

KFA showed growth in numbers while having lost the strategy. With the merger, it lost its brand image of a premium business class airline. It expanded with the speed of a jet without building a base and resolving the post merger challenges. This set the course for a bumpy ride.

3. Strategic Risk - Investment in Planes 

According to 31 March 2011 ending annual report, KFA flew 366 domestic flights and 28 international flights. It owned 67 aircraft.

“Aircraft Engine/Lease Rentals: Aircraft/engine lease rentals stood at Rs. 984 crore (USD 197 million) during the twelve month period from April 2010 to March 2011. Your Company operated 67 aircraft (scheduled and non scheduled) in the year under review, 13 of which are owned through finance leases and 54 are held under operating leases.”

Business Today article mentions that presently the airline owns 63 planes and a few have been returned to the lessors. However, the plane financing problem isn’t new. In September 2008, after the merger with Air Deccan,in financial results commentary KFA stated the following:

“Two aircraft have already been returned to Lessors with no additional cost, and the Company is in discussion for the return of a further eight aircraft. The impact of this capacity contraction will be visible during the second half of the Financial Year.”

After the merger, according to the Business Today article, the airline refused to take delivery of 5 Airbus A340-500. It had over 90 aircraft in Airbus books and no delivery was taken after 2008. This is a case of investment plans made under a cloud of unknowing.

4. Financial Risk – Excessive Debt  

In the December 2011 quarter unaudited financial results, signed by the Chairman Mr. Mallya, the following note is given:

The Company has incurred substantial losses and its net worth has been eroded. However, having regard to capital raising plans, group support, the request made by the Company to its bankers for further credit facilities, planned reconfiguration of aircrafts and other factors, these interim financial statements have been prepared on the basis that the Company is a going concern and that no adjustments are required to the carrying value of assets and liabilities.

KFA posted a loss of Rs 1027.39 crore (USD 205.95 million) in December 2011 quarter. As of 31 March 2011, its net worth was negative at Rs 3633.08 crore (USD 728.29 million). It was last positive in March 2008, and now the picture is dismal. Presently, KFA has a total debt of Rs 7057.08 crore (USD 1414 million) and total accumulated losses of Rs 6000 crore (USD 1202 million). The banks refuse to extend further  credit as the non-performing assets (NPA) will jeopardize the profitability and liquidity of the banks.

Here it is a clear case of excessive debt and poor cash flow management systems. The situation has gradually worsened from March 2008 and in three years the capital is completely eroded. A better financial risk management may have helped mitigate the problem. It appears no one in the company was monitoring the risk dashboard. Maybe they were flying high on optimism.

5. Operational Risk – Fuel Costs

It’s a well know fact in aviation industry that most airlines nosedive due to high fuel costs. The rise in fuel costs are an uncontrollable risks as the price of petrol is set internationally. Additionally, in India, states charge heavy sales tax on petrol. Hence, the fuel costs are much higher in India. KFA annual report of 31 March 2011 acknowledges this issue:

Aircraft fuel expenses: Expenditure on fuel stood at Rs. 2274 crore (USD 456 million) during the twelve month period from April 2010 to March 2011 accounting to 28% of the total costs. While the average fuel prices have come down from a high of Rs. 74 per litre in August 2008, prices have steadily risen through the year and ended 34% higher than prices at beginning of the year. 

As given in the commentary on the results for the half-year ended 30th September 2008, KFA was aware of the problem.:

The Aviation Industry is going through a challenging phase globally, driven primarily by spiraling fuel costs, which hit an un-precedent USD 147 per barrel in July 2008. The Indian industry was hit more adversely due to the cumulative impact of Customs Duty and Sales Tax on account of this sharp increase in international fuel prices. The average price of ATF in the six month period from April to September 2008 increased by about 60%. The impact on Kingfisher Airlines alone was to the tune of Rs.640 Crores (USD 128 million).

Most airlines to recover fuel costs increase the number of seats in the aircraft by better use of space. KFA couldn’t do it, as it projected itself as luxury class. Despite enjoying an occupancy rate of 75-85%, the company failed to break-even. Although the management was aware of the truculent factors in aviation industry it failed to take preemptive measures timely.

Closing Thoughts

A look at the 31 March 2011 year-end annual report reveals that KFA had 7-8 directors, with just one executive director. The audit committee had 3-4 directors and didn’t seem active, since there were just 4 meetings during the year. Since inception of the company, three CEOs have come and gone. Mr. Vijay Mallya, the Chairman, controls the company. The board of directors have not actively participated in charting the route of the company. Hence, pilot of the company is responsible for the downward spiral of KFA.  As the banks and government refuse to give a life jacket to KFA, the probability of safe landing is low.

References: 

  1. Kingfisher Airlines - Media statement 12 March 2012
  2. Kingfisher Airlines – 31 March 2011 Annual Report
  3. Kingfisher Airlines – 31 December 2011 Unaudited results
  4. Kingfisher Airlines – Commentary on results for half year ending 30 September 2008
  5. Losing Color – Business Today article.

Fraud Symptom 12 – Unethical Compromises by External Auditors

In the recent corporate frauds, auditors’ professional robes were soaked in dirty money. Their unblemished reputations tarnished, they dealt with allegations of compromising ethics, code of conduct and reporting responsibilities for self-interest and business opportunities. Auditors, the bastions of corporate governance and maintaining shareholders interests miserably failed in performing their duties. In some cases they failed to detect the frauds, and in others they collaborated with clients to facilitate them in conducting frauds.

The contract clauses of reasonable assurance, limited liability and others lets them escape criminal liabilities usually. The regulators, shareholders, employees, third parties and the public helplessly watch the organization going bankrupt and/or closing down because auditors failed to detect wrong doing or failed to report the same. The financial crises showed that without due care, global economies go in recession. That should make auditors more responsible; however, it is not the case.

Francine McKenna author of blog re: The auditors  is a pro in digging dirt about big four and openly shares her views. This extract from her blog shows the interrelationships between big four and corporate giants. With these relationships independence of external auditors is easily questionable and suspect frequent compromises. Though I normally don’t post big extracts from other blogs, this one is too good to miss.

“KPMG audits Citigroup, Wells Fargo – who now owns client Wachovia – GE, and GM.  They used to audit two big mortgage originators before they blew up – Countrywide and New Century. They also used to audit Fannie Mae and Moody’s before they were fired and sued. They also audit the US Treasury.

PricewaterhouseCoopers audits JP Morgan Chase, Bank of America, Goldman Sachs, AIG, the Federal Home Loan Banks, and Freddie Mac. PwC is also responsible for Satyam, Northern Rock in the UK, Glitnir in Iceland, and Russia’s Yukos.

Deloitte, who is now Fannie Mae’s auditor, was also auditor of four other housing related companies that had issues: Taylor Bean & Whitaker, Beazer, Novastar, and American Home. (The bank that TBW bankrupted, Colonial Bank was audited by PwC.) Deloitte audited three no-longer-independent large firms sunk by bad mortgages: Merrill Lynch, Bear Stearns, and Royal Bank of Scotland. Deloitte used to audit Washington Mutual before it was taken over forcibly by JP Morgan. They also audit the Federal Reserve Bank and Buffett’s Berkshire Hathaway.

Ernst & Young, everyone knows, audited Lehman Brothers. But don’t forget UBS and Societe Generale, home of the “rogue” traders, and Anglo Irish in Ireland. EY also audits News Corp and S&P, the ratings agency.”

The issue is can shareholders expect auditors to report independently and forgo lucrative business to adhere to ethical standards. Audit organizations need an organization culture that focuses on social responsibility with profit motive. However, some successful ones have a competitive aggressive culture that fails to build in the ethical aspects of auditing.

Therefore, the cultural climate in auditing firms raises questions. The research  paper “Public Accountants’ Perceptions of Ethical Work Climate” authored by Howard Buchan  evaluates Ethical Climate Questionnaire developed by Victor & Cullen for public accountant firms. The following questions were asked from partners to staff to assess the instrumental climate.:

  • “E1 In this Firm, people protect their own interests above all else._____
  • E2 In this Firm, people are mostly out for themselves._____
  • E3 There is no room for one’s own personal morals or ethics in this Firm._____
  • E4 People are expected to do anything to further the Firm’s interests, regardless of the consequences._____
  • E5 People here are concerned with the Firm’s interests-to the exclusion of all else._____
  • E6 Work is considered substandard only when it hurts the Firm’s interests._____
  • E7 The major responsibility of people in the Firm is to control costs._____”

The instrumental climate emphasizes individual self-interest and company interests above all others. Though the study mentions that participants didn’t perceive an instrumental climate, the mean responses ranged from between “mostly false” to “somewhat false”. The results indicate that partners and junior staff perceive ethical climate differently in the firms. Hence, more focus is required on building an ethical culture within the auditing firms

Moreover, though audit firms have been asked by regulators to segregate non-audit and consulting practices, the  bifurcation is cosmetic and not in spirit. A recent example is of PWC India whose partners were implicated in the Satyam fraud.  Times of India reported the insurance claim by PWC for Satyam fraud is fraught with irregularities and arms length distance was not maintained between various PWC entities as required by Institute of Chartered Accountants of India (ICAI).

Price Waterhouse (PW) Bangalore, the tainted auditor of scam-hit Satyam, utilized over 95% of a $60-million (Rs 280 crore approximately) insurance cover available to all Price Waterhouse entities in India to meet post-fraud litigation expenses and damages without paying a single rupee towards the premium. The revelation raises questions about the arguments put forth by the global financial services company that each of its Indian firms is a separate legal entity and not responsible for the acts or omissions of any other member firm. 

PW Bangalore, which had the mandate for the Satyam audit before the fraud came to light in 2009, did not contribute any money towards the Professional Indemnity Insurance (PII) of $60 million, but surprisingly enjoyed the cover when it faced trouble and litigation for the lax audit, documents accessed by TOI showed. PW Bangalore even used the cover to pay $15.5 million towards settlement of a class-action suit filed against it in the US. Till financial year 2011, various entities of PricewaterhouseCoopers India (PwC India)-including a private limited company which renders only non-audit related services-had a common insurance cover. “

The blame for the malpractices has to be shared by regulators, board of directors and shareholders. Most of the fortune 500 companies select big four as auditors. Though audit committees are required to annually review and recommend auditors, in most cases the auditors are not changed. In my previous post on audit committees, I had mentioned this data from Economic Times article – “Can the big four survive a break-up attempt”.

  • In top 100 (US) companies, the average tenure of audit firms was 28 years. 20 companies had the same audit firm for 50 years or more.
  • 85% of the companies in EU are audited by big four.
  • 99% of the audit fees paid by FTSE 100 (UK) in 2010 were earned by big four.
  • Just 2.3% of FTSE firms changed their auditor between 2002 and 2010.

Without regulators taking their responsibilities seriously the audit firms aren’t going to change. For instance, ICAI disciplinary committee for chartered accountants have big four partners as members. In other committees also, big four partners have an influential position. Considering this, it is not surprising that the disciplinary process is slow, as was in the case of Satyam.

Recommendations

1. Regulators must lobby for laws to mandate audit firms rotations. For instance, the new Companies Bill 2011 (India)  requires rotation of audit firm every 5 years and audit partner every 3 years. It also states that no audit firm will audit a company for more than 10 years. These laws will ensure some level of independence and also give a growth option to other audit firms.

2. ICAI and other institutes granting permission for practice to audit firms may periodically conduct an assessment to evaluate the ethical climate of the firm.

3. ICAI and other institutes should either segregate disciplinary responsibilities to another organization or become proactive in disciplining errant chartered accountants.

4. Audit committees, boards and shareholders must proactively manage the appointment of audit firms and evaluate the financial reporting systems.

5. Audit firms should take a leaf out of their own book and focus on building a benevolent organization culture to balance their social responsibility with profit earning objectives.

References:

  1. re: The Auditors by Francine McKenna
  2. PwC arm’s insurance cover under cloud – Times of India 29 February 2012
  3. Public Accountants’ Perceptions of Ethical Work Climate: An Exploratory Study of the Difference Between Partners and Employees within the Instrumental Dimension by Howard Buchan

If you wish to read the Fraud Symptoms series, click here.