Anatomy of a financial system collapse - Part 2

The devil lies in the financial statements. These financial statements are audited by an auditor to vouch for the truth and fairness of the financial information. Hence, the audit report becomes very important.

Why is the audit report so important?

The basic purpose of relying on audited financial statements for estimating the future viability of a business (in turn funding it's expansion) is that the user of the financial statements relies on the impeccability of the attest function. The attest function is the audit performed by an auditor, to evaluate all the financial data contained in the financial statements, and expressing an opinion on them.

That is what any audit process is geared to deliver as an output. All the auditing standards, the use of guidance notes on audit and accounting matters and the the accounting standards are meant to present the financial information that is very useful to the user of the financial statements.

I must point out that what I will explain hereafter are exceptions to rule. Auditors are very responsible professionals. They are aware of their responsibilities and stick to them in the course of discharging their functions. They utilise their expertise in the accounting and auditing domains to the discharge of their functions to the best of their abilities.

Accounting expertise and it's use

The flip side of the expertise that is acquired by a professional expert, in any domain, is that it allows him to manipulate the system. If I know how to structure a transaction in a way that I've hidden transactions that can be termed as fraudulent, then I can very much create a any numbers in the financial statements that don't reflect the truth.

Let's take the case of Ashwin Ltd. The company managed to get a loan of ₹800 crores based on his audited financial statements that were provided to MOLGA. If Ashwin Ltd. moves one transaction that is an expense in his books and shows it as a receivable from another third party, then it will truly affect the profitability that is reflected in the Profit & Loss Account. Ashwin Ltd manages to show expenses of ₹300 crores (this is a cumulative amount) as a receivable from a third party Vivek, then this ₹300 crores is being depicted as an asset in the book. This amount has indirectly inflated the amount of profit and the assets that are owned by Ashwin Ltd. The amount can change the mind of a prospective lender on providing a future loan to Ashwin Ltd.

If MOLGA had disclosed this transaction, then the decision of providing the loan of ₹800 crores could have been different. This misstatement will be revealed to any auditor worth his salt. Most auditors will detect this transaction. It won't matter how skilful the accountant has been, this sort of transaction will be smelt out by the auditor. 

The Opinion on financial statements

This is where the goose is cooked. The audit report. The auditor essentially expresses an opinion on the financial statements in an audit report. Most of the times these are just cut, copy and paste exercises. That happens when everything is normal and there is nothing of any importance to report.

The opinion expressed by an auditor affects how the user interprets the financial statements. There are basically four types of opinions that an auditor can express in an audit report.

1) An unqualified Opinion

2) A qualified Opinion

3) An adverse Opinion

4) A disclaimer of an Opinion

Unqualified Opinion - When there aren't any material misstatements in the financial statements that the auditor needs to bring out in the audit report. And when there are not any misstatements that will affect the financial statements materially, the auditor expresses an unqualified opinion.

Qualified opinion - As per standard on auditing 705-Modifications to Independent Auditor's Report

"The auditor shall express a qualified opinion when:

(a) The auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are material, but not pervasive, to the financial statements; or

(b) The auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, but the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive."

Adverse opinion - As per standard on auditing 705-Modifications to Independent Auditor's Report

"The auditor shall express an adverse opinion when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are both material and pervasive to the financial statements."

Disclaimer of an opinion - As per standard on auditing 705-Modifications to Independent Auditor's Report

"The auditor shall disclaim an opinion when the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive."

The above shows that an auditor (an external auditor or an independent auditor) can express different types of opinions which suit the situation.

Audit Evidence

Before expressing any of the above opinions on the financial statements, the auditor has to collect sufficient audit evidence to support it. The evidence would be mostly contained in the internal documents of the auditee(the client). This would include all the internal documents. If an internal document about maintenance of fixed assets of a company indicates that there is no responsibility devolved on any individual for maintaining and control of the fixed asset, then that automatically affects the reliability of the value that is attached to the asset. 

Why? It's because the management of any entity has to make sure that all the assets owned by it is under control of an authority and steps to maintain it for productive use. The ability to use any asset for a productive activity is what gives the asset the value that is mentioned in the financial statements. Similarly, any encumbrances (liens, mortgage etc) that are placed on an asset is also part of the evidence that should be collected by the auditor. If an asset has been pledged or hypothecated to a third party, then that disclosure is required on the face of the financial statements (in the notes to accounts)

The above explanation of audit evidence is a very generic one. But, audit evidence is a primary requirement to corroborate any opinion that the auditor will express on the financial statements.

The Auditor's Responsibilities Relating to Fraud in Audit of Financial Statements-Standard on Auditing Number 240

"4. The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. It is important that management, with the oversight of those charged with governance, place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty and ethical behavior which can be reinforced by an active oversight by those charged with governance. In exercising oversight responsibility, those charged with governance consider the potential for override of controls or other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in order to influence the perceptions of analysts as to the entity’s performance and profitability. "

If you read the above paragraph from the standard on auditing number 240, you can see that the auditor is basically absolved of all responsibility in case of a systematic fraud. There are various other paragraphs that are prescribed in the format of an Independent Auditor's Report issued by ICAI but the same is not relevant here.

Good money chasing bad money

Let's go back to Ashwin Ltd. Ashwin Ltd has approached MOLGA for another loan. This could be a term loan or a working capital loan (both have slightly different requirements with respect to the due diligence that has to be performed). Now, Ashwin Ltd has a debt to equity ratio of 2:1. This is a comfortable threshold. He doesn't have any additional equity that can be brought in to fund his business. His business has hit a fund crunch as a result of the cyclical nature of his industry. It's not unique to Ashwin Ltd but pervasive to all industry constituents.

Ashwin Ltd has defaulted on his loan repayments to MOLGA. If it defaults on the loan repayments for even 30 days, it will be classified as a non performing asset. This basically means that it can't take any further loan from MOLGA. Although, if there isn't sharing of information between different lenders, then Ashwin Ltd can approach another lender to fund his business. Since, the business is going through a slump, the profitability position based on which ₹800 crores were lent to Ashwin Ltd 5 years ago will not be existing currently. This should be reflected in the financial statements. Since Ashwin Ltd has defaulted on his repayments, it should be flagged as NPA. If the same situation persists till 90 days then the Ashwin Ltd has to be categorised as NPA. What this means is that the lender cannot recognise any income that is receivable from Ashwin Ltd in his books of accounts unless they have actually realised. It means suspension of accrual of income. Now, in such a scenario nobody in their right mind should be ready to lend money to Ashwin Ltd. Right?

Wrong! Check out what Mint has to say about this. http://www.livemint.com/Industry/D6hWDMs7XYX6jed2wnBCRO/Govt-flags-concerns-over-evergreening-of-loans.html

Ever greening of loans is basically lenders refinancing unpaid dues into another loan. This is usually done to avoid losing a big customer who has a huge loan book. This is a business practice of many lenders. Imagine if you have to categorise a customer who has a loan outstanding of ₹5,000 crores, as NPA. That's a big chunk of your business that is not accruing any income. Imagine that this isn't the case for only one customer. There are many more. The numbers could be mind boggling.
Since the financial crisis banks have been limping from one financial year end to another. The recent instance of th Syndicate Bank MD being arrested on charges of bribery to provide loan come to mind. Check out what the former CBI chief has to say about this bribery case. http://businesstoday.intoday.in/story/bhushan-steel-syndicate-bank-cbi-neeraj-singal/1/209550.html

LANCO also comes to mind. It has around ₹50,0000 crores outstanding with a number of lenders. It's business is not profitable. It's not able to repay its debts. But, they are seeking new loans to fund individual projects to pay off the debt piecemeal. This is just like good money chasing bad money. LANCO isn't making money from its business. The lenders are getting jittery because if it fails to repay its loans, then they will all take a huge hit. The largest lender to LANCO is SBI. Imagine if SBI had to take a hit of writing off a huge chunk of its loans. LANCO is busy selling a lot of its assets so that they can repay their debts to the lenders. Check out this article in the Wall Street Journal which talks about them selling out power projects to pair down their debt.http://online.wsj.com/articles/indias-lanco-to-sell-assets-to-raise-829-million-1410276320
As a result of the recent Supreme Court judgment, most companies whose business was dependent on captive coal mines being mined for producing power or using the coal further in their business, will also bear a huge shock on their financials. This in turn will impair their ability to repay the loans they had tied up with banks and financial institution.

Disclosures in Financial Statement

When you have a business that is willingly not following accounting policies that are statutorily mandated, and the same is not being disclodsed on the face of the financial statements, then you know there is something seriously wrong in the disclosures that are contained therein.
Let's go back to the opinion of the auditor. The auditor of the lender and the auditor of the lender have to express an opinion on the financial statements of the lender and the lendee. In case of Ashwin Ltd, the auditor has to express his opinion on the disclosures that are required by regulations in the financial statements, and that these disclosures are true and fair.

Since Ashwin has gone through a slump in his business, he is not making profits. If you are not making profits, then you are not going to get funding from and lender. So on the face of it, the business has to appear to make profits. Like I explained in part 1, this can be done easily through accounting gimmickry. If Ashwin Ltd has a consolidated expense of ₹500 crores that is bringing his profits down, then this can be shown as a receivable amount from some third party. This reduces the expenses that have been recorded in the profit and loss account. And as a result, the profit has been inflated ip by ₹500 crores. This inflation in the profit will make him eligible for a new loan.

Remember, Ashwin Ltd has a history of non payment with MOLGA. But the profits reflecting at the face of the financial statements will soothe any anxiety of the lender. The current profits vouch for future profits.

In conduct of an audit, the auditor has to collect evidence. He also has to collect independent evidences for confirming balances that are maintained with third parties. This is done as or the standards on auditing. Hence, all auditors have to follow this practice. It is assumed that the third party has less incentive to fudge the confirmation of the balances. So, if Ashwin Ltd has fudged his books, then the ₹500 crores balance purportedly maintained with a third party would be revealed as fake. Hence, the ideal methodology would be to transfer this balance to a sister concern or a subsidiary which isn't a public company. Mind you this practice is patently illegal, but if you don't have money to fund your business then you have to become creative.

Auditor is the conscience keeper of the numbers

This is where the statutory auditor has to come in. The evidences have to be diligently collected and the assertions in the financial statements have to be analysed threadbare as to its veracity. If the auditor chooses his audit methodology correctly, then he would detect this bogus transaction. But, if the auditor is co-opted in this endeavour then this 'misstatement' will never come to the fore. If the auditor doesn't detect this misstatement (willingly or unwillingly) then he has basically not performed his duty with respect to the audit function. 

The audit report will legitimize the assertions in the financial statements. And as a result, other people will rely on the audit report to take business decisions. Like MOLGA who will decide on the new loan proposal of Ashwin Ltd.

If certain disclosures are not made on the face of the financial statements, the onus of doing so has to be shared by the auditee and the auditor. The auditee because the responsibility of preparing the financial statements lies with the entity being audited and the auditor because the onus of expressing an opinion on the financial statements is borne by him. If either of the two fail in their responsibility, then both should be liable to face the consequences.

Anatomy of a financial system collapse - Part 1

What is a banking or financial system collapse? What happens to the system when those who are supposed to fund future economic activity, end up saddled with distressed assets and are no longer engines of economic productivity? Does the system collapse? It might. But there's a way out.

From the little experience that I have in auditing banks, I will try to explain how it really happens.

Let's start this explanation with a story.

How does one source a loan?

Ashwin wants to start a business. To start a business, he will need capital i.e. money. He either brings in his own equity (personal funds) or he uses debt (loans) to fund his business. 

Debt is obviously not going to fund his entire business activity.  No banker/lender in his right mind will lend him any money without Ashwin himself investing his own money. This is how the banker/lender ensures that the promoter will not just abandon his business when it becomes unsustainable. If Ashwin has pumped in his own money into his business, he is more likely to make sure that it makes profits. Or at least try till he succeeds. After all a lender will only fund a profitable business. 

To estimate future profitability of a business, a lot of financial analysis is conducted. We'll get to that a little later.

Due diligence

Bankers have various measures to make sure that there is adequate equity of the promoter. The most basic among these measures is the debt-equity ratio. It measures the Total Amount of Debt against the Total Amount of equity. Say if Ashwin's business has his own money (equity) worth ₹100 and Debt worth ₹200, then the debt-to-equity ratio is 2:1. This used along with the financial leverage ratio gives a very crude idea to a lender about the amount of debt in the company and the ability of a business to meet its financial obligations. 

Financial leverage relates only to the interest payments (being fixed costs). There are other ways to measure financial leverage. I'll direct you to investopedia for any further reading on leverage.http://www.investopedia.com/terms/l/leverageratio.asp

Basically, a highly leveraged company means a company with high amount of debt in its books of account/business. A highly leveraged company has to make a lot of fixed interest payments. Hence, it will have little surplus profits remaining that could be used to fund future business expansion (if used as equity infusion for business expansion) 

This is referred to as internal accruals. This surplus can be distributed to the shareholder/owners of the business or invested back into the business.

Every industry has a norm to which the lenders/bankers use to analyse a loan proposal. For each new loan proposal that comes to a lender/banker, a project report has to be submitted. This project report is authored by a Chartered Accountant(CA). He analyses the future business proposal, the estimation of revenue, costs and value of the assets hypothecated as security for a loan. He also assesses the viability of the proposal in general. 

Most of the numbers that this report relies on is sourced from the financial statements of the entity in question. The basis for future profitability estimation and valuation of assets (and as a result valuation of the business) is dependent on the foundation of the numbers stated in the audited financial statements of the most recent, preceding, accounting year.

Who is eligible to audit banks/financial institutions?

The money that is used to disburse loans to fund economic activity by the banker/lender, is owned by the shareholders or the depositors. Hence, there has to be a lot of due diligence done before a loan is sanctioned to a lender. Hence, bankers/lenders have some of the most stringent auditing norms that are prescribed by the Reserve Bank of India (RBI). The CAs who are eligible to conduct bank audits have to be empaneled by the RBI. Only the empaneled auditors(audit firms) are eligible to conduct bank audits. Not all firms qualify, and only those who do, are eligible to be appointed as auditors of banks. 

A similar empaneled group of auditors are identified to conduct audits of non banking financial institutions. NBFCs have a similar business model of lending money to borrowers. But, they are not allowed to receive deposits like banks. Banks receive depositors' money for lending to their customer under strict norms of the RBI. NBFCs also are subject to lending norms, but they are not as stringent as the ones that are applicable to banks.

The auditors who are empaneled are eligible to conduct two types of audits - statutory audits and concurrent audits. Concurrent audit is an extension of the internal audit function of the bank/financial institution. These are conducted at branch level, circle level, regional office level and central office level.

If a bank/financial institution has a full fledged internal audit department, then the concurrent audit function isn't as extensive as it would be in case if there wasn't an internal audit department.

The other type of audit is the statutory audit function. This function entails expressing an opinion on the financial statements of a bank/financial institution. This is a really crucial function. The performance of the statutory audit function informs the shareholders of the financial position of the entity. Based on this opinion the shareholders can assess the future viability of the business.

A similar audit function is also applicable to other businesses. The norms differ from industry to industry. The regulators for these industries are responsibile for implementing the rules and regulations for their respective industries.

Who sets the rules and regulations with respect to the audit function?

The nodal institution of CAs, the Institiute of Chartered Accountants of India (ICAI), imposes professional responsibilities on its members. The ICAI regulates the auditing profession in India. Hence, all audit related rules and regulations that are imposed on CAs, and also discharge of other services by a CA in his capacity as a member of the ICAI, comes directly under the purview of the ICAI.

What did Ashwin do to fund his business?

Let us go back to Ashwin. His company Ashwin Ltd has been in the business of producing product X,Y, ZA, B, C & D for 5 years now. His business is picking up and he wants to move into a different business geography. He will need to set up a new manufacturing plant and buy raw material to manufacture these products. He will also need to hire new employees and pay them competitive wages. He only has ₹400 crores. He goes to a bank called MOLGA. MOLGA relies on the project report of the new venture of Ashwin Ltd and the financial statements of Ashwin Ltd that are audited by a CA.

The Audit Opinion

Based on the audit opinion which is contained in the audit report, the user of the financial statements and audit report makes an informed decision about the viability of the business and the numbers that are contained in the financial statements. Hence, the function discharged by CAs in various capacities are extremely important to a lot of people who use them in good faith.

So Ashwin Ltd gets a loan of ₹800 crores based on the analysis done by MOLGA on the future business prospects. The foundation for this analysis is the financial information contained in the financial statements of Ashwin Ltd. The opinion expressed by Ashwin Ltd's auditor either validates the financial assertions in the financial statements or disagrees with it. Let's say it agrees with it. Then, in effect the auditor has issued an 'Unqualified Opinion' on the financial statements of Ashwin Ltd.

What about the numbers?

What if all the numbers that have been used to analyse the loan proposal of Ashwin Ltd of ₹800 crores have been fudged? What if those who are supposed to rely on a piece of paper containing financial information, that will determine the destiny of the money pumped in by shareholders, and that borrowed from depositors, make a decision on the viability of a loan proposal based on financial information that has been 'cooked up'?

Imagine if this pattern is far more prevalent than what can be discerned. What would that do to the financial system?

P.S. To be continued