Net Neutrality: Why should a network be neutral?

Why is everyone debating so passionately about network neutrality in India? Why does it even matter to anyone whether a network is neutral or not? This question has popped into all our heads when the media coverage of this debate reached a crescendo before December 30th 2015 and it will again do so before January 7th 2016.

The debate here is essentially whether the network that is the internet should be controlled by a few or should it be democratic. Democracy would mean that the people who populate the would would control the content that is created on the internet.

Television and Internet

Alright, so let's go back in the past for a bit. The television revolution in this country began in the early 90s. It allowed us to watch new age programming (for those of us who remember Doordarshan) and allowed content creators to experiment with different formats. It popularized sports broadcast and also led to the eventual explosion of the television news business. There was one problem. The broadcaster had to pay our local cable operators(CO)/multi-system operator(MSO) to be available on your television screen. This payment is called the carriage fees. If I couldn't pay the carriage fees, my channel wouldn't feature on the cable network.

Long story short, those who owned the network owned the broadcasting business. This is still the case. The cable digitization drive will move the cable business from an analog signal to a digital signal. This will allow the broadcasters to measure their subscribers accurately. It will also help in sharing of the subscription revenues between . It will help in better tracking of the television rating points (TRP), the lifeblood of the cable /direct-to-home (DTH) TV industry. TRPs allow marketers to measure the audience of a particular TV show or channel. TRPs help the marketers decide where they should place their ads to maximize the reach of a marketing campaign.

So in all every medium of communication should allow monetization for it to be able to sustain itself. Take newspapers, magazines, television news channels, entertainment channels etc. The fact that television media was owned by the messenger (cable TV companies) and not the content creator (broadcast companies) is what led to the broadcasting business being a very expensive business. The listed media companies in India like NDTV, Network 18 (before Reliance acquired it) and India Today group were all in debt. This is because the television business entails huge fixed costs to get the business rolling.

Internet is democratic

The Internet is democratic. It allows the content creator and the content distributor (internet service providers and companies like Facebook, YouTube and Netflix ) an equal footing on the medium. Initially, there were only a few content creators on the Internet.

As the adoption of the Internet grew, we saw companies like YouTube and Netflix come up. These guys put the creators and the consumers on a platform, so that the consumer could choose which content he/she could consume. Hence, there was more content out there to consume and the internet made it one click away.

Facebook the behemoth

Then came Facebook. Facebook's business model is predicated on the idea that as long as people are on Facebook, it will make money. That's the whole point of the medium. It's a good business though.

Imagine having all the knowledge about the likes and dislikes of almost 1 billion users of the Internet. If you actually go through Facebook's terms and conditions, it says that Facebook can do whatever it wants with any and every byte of date you share on Facebook. This data can be used to target ads at Facebook's users. Facebook needs more people on its network to justify its valuation.

The more people it has on Facebook the more data it has to sell to marketers and advertisers to tailor ads at Facebook's users. Every like and dislike that you share on Facebook can be used to target a certain product at you. This is why Facebook is free. It's users are the product to Facebook. The customers are the companies that pay money so that we see ads on Facebook on our news feed.

If Facebook owns the platform through which you access the Internet, then they have more than the data that the need. How? An Internet user accessing any website through Free Basics would be sharing all of his/her browsing information with Facebook. This is because Facebook would be the gateway to the Internet. More information means more money. It's a simple equation.

What's in it for the telco?

In telecom parlance, this is called Average Revenue Per Unit (ARPU). It means the average revenue a telco has earned from a user on its network. This would include the calls that we make and the internet usage that we indulge in on our devices.

Most telcos are obsessed with their ARPUs. A higher ARPU means that the average customer is earning the telco more money. In India, ARPUs have stagnated (put the number here). Data (i.e. Internet) is the next big play that is going to earn the telcos more money. Imagine the possibilities. There are tests that have happened in the U.S. which may provide over 250 GB per second Internet speed. Well, what does that mean Vivek? Why should that matter to me?

We are going to abandon television very soon. The sheer speed and the targeted marketing ability of the Internet is going to cannibalize the broadcasters. The broadcasters are already seeing this trend and want to turn into a multimedia players.

Don't believe me? Google your favorite television show and there might be a pay per view or even a free streaming service available for it. Do you think you're going to spend 600-700 bucks for a television package in ten years? And this is in terms of today's value of money. This amount might be higher in the future considering inflation. Internet pricing will only get cheaper over a period of time as more people would adopt the internet.

Imagine a day when you won't think twice before having 2 GB per second Internet bandwidth at a reasonable price. If the speed increases higher than that, it might just replace your DTH or cable TV. Apple TV and Amazon Fire are examples of this.

The point being telcos have realized that they would remain only a utility provider if they can't have differential pricing for data. They won't earn even a slice of the ad revenue that content providers would be earning through their content. This is because the current model means YouTube owns the platform and hence gets to collect money from the ads. The argument of the telcos is that it's their infrastructure (and since the ARPU from voice calls has gone down) they need to protect their business and be allowed to have differential data pricing.

But why should the network be neutral?

Net neutrality activists say that the Internet was formed with an open architecture. It is supposed to be a connection of several networks across the world. If I enter the web address of a particular webpage in my browser, then I am essentially directed to that webpage as fast as my internet bandwidth would allow me to. Differential data pricing would on the other hand remove this parity. If Google paid my telco more money, then they get a leg up and load faster. And if say a small time media startup couldn't pay that money, then it would have to load slowly.

What's wrong with this you say? Shouldn't anybody who is ready to pay be allowed preferential access? Remember the cable TV industry story in the beginning and the carriage fees? It created a huge entry barrier for new players in the broadcasting space. Only those with deep pockets could feature on a cable or DTH network. There was no level playing field. 

The channels that were available on the network depended more on the abilities of the content distributor and content creator to hash out their business deals. In effect, the content creator (can be you and me) couldn't negotiate from a position of strength. This led to content being created by very few people. The Internet has changed all of that. It gave the power back to the content creator. Content over the Internet could mean any information -audio, visual or text.

Wouldn't' you want a cash cow that will allow you to make money just by having a regulator make a few changes in the regulations for you? The forces of the market are too difficult to handle you see. Profits are too precious not to protect. It would be better if telcos and Facebook own the whole space and make their own deals to share the piece of a huge pie. It's better if they get the deal done before anyone is looking.

P.S. I must admit that a lot here about the media landscape in the early 90s isn't my own thinking.. Most of my understanding is borrowed from the writings of Vanita Kohli-Khandekar. She has been covering the media industry in India since the early 90s. Reading her work would be really helpful.

The illusion of choice

"Everything begins with choice," said Morpheus. The Merovingian looked at him, with his steely eyes and says, "Choice is an illusion created between those with power and those without."

That's a dialogue from The Matrix Reloaded, a seminal film which institutionalized the kind of computer graphics that you see in movies today. This dialogue defines what is wrong with free market capitalism. It's the illusion of choice. The smokescreen of corporate induced propaganda that promotes crony capitalism. This crony capitalism only worries about profit and not the essential element of free markets- choice. It's letting the consumer choose from the available ideas in a market place of ideas. This could be an ideology, a product, service or a political line.

The basic idea of a free market would be, no one idea or person can dominate another. They should get equal space and equal opportunity to make their case. There should be a proliferation of ideas from across the political and economic spectrum. That would mean that I as an individual would have the liberty to choose what I would do with the limited resources that I have at my disposal. The resources could be anything, like my time and my energy. But to make it simpler, let's call it money.

If money is the means of transaction, then I should be able to buy what I want with an unbiased mind and exchange that money for something that I would value. This maybe food, clothing or luxury items like a iPhone 6S or the MacBook Pro. If I am allowed to make this choice taking in only what I need from the discourse, the value of the money that I have in my hand and the incremental value that exchanging the money, say ₹ 50,000, then it would be an unbiased choice.

But what happens when this choice isn't unbiased. What if everything doesn't begin with choice as Morpheus claims it to be. Then you have an illusion of a make believe world where one's choice is only as unbiased as our ignorance. 

Take the Nairobi WTO ministerial meetings for example. India was trying to protect its farmers from excessive agricultural imports from countries which subsidize their farmers' produce and allowing India to procure food grains from farmers to feed its hungry population.

The claim of the WTO (read western developed nations) is that such a system would fly in the face of free trade and would distort world trade. The reasons given are that the food grains that India purchases from its farmers using the minimum support price and then sells them to the needy at lower prices, floods the market with cheap 'distortionist' food grains. This stock of food grains could be sold in the international market and would 'distort' trade. Well, my problem isn't with this whole line of argument.

Look at it this way. What does the subsidy do? It tells the farmer that if you produce crop A, then the government would reward him by buying the harvest from her at a pre-decided price. This is taking away the choice from the farmer to pursue his own economic well being. Well, then how do you feed a country full of hungry people? Shouldn't the government be doing something about it? That's a noble idea, but when you tie in fertilizer benefits along with the kind of crop that is grown, it doesn't allow the farmer grow the crop that he would ideally like. Mihir Sharma explains this concept in detail in his book Restart.

Countries will always pursue distortionist trade practices that would benefit their people. That's a given. But the problem arises when a sovereirgn government is forced into taking decisions based on corporate lobbies. That's distorting the element of choice that one should enjoy in a free market of ideas. This is an ideal situation that we can never achieve, but hey if democracy is a process and is never ending, then why not strive towards another ideal. 

As The Merovingian rightly said, choice is an illusion. This illusion is created by those who want to maximize profits and create perpetual monopolies. They don't want credible regulators who put the consumers' interest first. These corporate giants want to maximize their profits so that they can have good quarter ending call with analysts. They can't see beyond the red and black of the profit and loss account at the end of the quarter. They can't see beyond profit projections that give a hard on to market analysts in predicting the next big bull run. They aren't the ones one should look to for the unattainable goal of a free market of ideas.

Then who must give the people the ability to make an unbiased choice?

"That, detective, is the right question," said Dr. Lanning, to Detective Spooner, in the movie iRobot.

It's the people stupid. It's the people.

Mann ki baat: Mitron, I oversold the 'Acche Din'

Hello Mitron. I am writing this after coming to terms with the reality of the 'Acche Din' project that we had embarked upon. It has come to my attention that we may have gotten ahead of ourselves. The enormity of the task has dawned upon me. The newspapers claim that I don't have talent in my cabinet. This contention might be true. But I will strive to steer us towards the promised land of the 'Acche Din'.

Let me enumerate how bad things are. But before you go through them all do remember, I have performed in the past. And I shall strive to do so even in the face of extreme adversity. This is my promise.

1) Our economy is in bad shape- Duh! If you had to be told that then you are one stupid person. We had performed incredibly well over the past decade beginning from the last few years of Atalji's govt because of export led growth. We didn't create incremental jobs. In fact, as the good doctor (my predecessor) would agree it was jobless growth that took place. This makes my task even more difficult as I have to not just deliver growth, but also deliver jobs. Check out what Ruchir Sharma says about the type of growth emerging market economies have had over the last decade. http://www.ndtv.com/video/player/india-forecasts/india-forecasts-top-10-economic-trends-in-2015/351747?curl=1421123064 I know it's NDTV, but Ruchir makes sense. I am gonna lump it.

2) The world economy is in bad shape- We were riding the global boom a decade ago. And the whole world is in tatters right now. People aren't willing to spend money, but I promised you'll the world. Mitron, do have faith in this humble servant. I shall strive to deliver.

3) Banks are saddled with debt- That's a shocker. I called a meeting of all the bankers in the serene town of Pune. They were promised that we won't meddle in their business decision, 'unless they're against in public interest'. But, Mitron they live in hard times. They've funded so many projects which haven't seen light of the day, that they've lost the appetite for funding any new ventures. Yes, SBI did fund Gautam bhai's mining project. But, it was just a one off. And then there were so many questions on that deal. I really like Raghuram bhai. He's finally delivered the rate cut that was needed. Now I need to speak to Jaitelyji and find out how the rest of the investment cycle has to be pushed forward.

4) Wait for our first full budget - Bhaiyo behno, we must wait for the budget before you write off any hope for a revival. There are many goodies in store for all the hopefuls. We shall strive to deliver a 'India first' budget. But to I hear to kickstart the investment cycle, we might have to take up the Keynesian method of running up a deficit and spending money to signal intent.

5) Mininmum Govt Maximum governance - This is one of my core beliefs. But for that we must sell off a lot of our centrally owned companies. You have all seen the drama created by the Coal India Limited employees. They almost created a power crisis in the country. Someone said that I am following the Thatcher way of taming coal workers. But, I am just following my heart and the manifesto I presented before y'all. Watch this space for more on the slogan.

6) Lack of talent - As you may have heard, I am facing a shortage of talent in my cabinet ministers. I am trying to remedy the situation by changing things around, but I am going to deal with this very soon. Hope Mr. Panagariya gets cracking at his new job and gives us actionable policy views. That can help me deal with the lack of talent.

7) The motor mouths - This is not much of a problem but an embarrassment and a distraction. My whole extended parivar  thinks that we must go back into the past and chase the irredentist goal of being a homogenous country. I know this is something I have to deal with eventually, but I am busy setting things right in the governance structure. Amit bhai has already sent a notice to Maharajji. I hope you'll show some patience. This humble servant shall keep these morons under check very soon.

Consumer Loans are toxic!

So I recently managed to convince my friend not to use his credit card to convert his purchases into EMIs. Yay!

What's the big deal you may ask? Let's check out why he wanted to convert them into EMIs. The normal reason is that he doesn't have enough money to pay for the expenditure that he is about to incur. Well, he's my age and I get that at our age there are certain expenses that we just can't avoid.

So I asked him what are the expenses that he usually converts into EMIs. Here's an illustrative list that we had a heated discussion-

1) Whey protein powder

2) Flight tickets

3) Consumer goods i.e. Cell phones, Television, Washing Machine etc.

4) Gifts

Now what is the one thing in common with these expenses? They're all discretionary. Since, the credit card company allows him to split his current expenditure and transfer it to subsequent months, my friend thinks that he is able to defray his expenditure eventually. This not just wrong, it's foolish. Why is that? Because no credit card company is going to give you a 'interest free' EMI. That's just not how these companies are going to work. To cut the long story short, there's no free lunch. He will be charged some kind of fees and/or a monthly interest rate to cover this up. Sometimes, the credit card company may have a deal with the retailer or the manufacturer to provide a discount to the customer. Here is where you might see messages like 'Interest Free EMIs'. From all the finance education that I have gathered, this just doesn't happen. There's a charge hidden somewhere that he has to pay.

Check out this article in the times of India that I found while doing research for this blog. http://timesofindia.indiatimes.com/business/india-business/RBI-bans-zero-interest-loans-on-EMI-to-credit-card-holders/articleshow/23065529.cms

What would have been the end result if I hadn't managed to convince him that converting purchases into EMIs are wrong? He would have overspent. And he would have gotten into the habit of purchasing more than he could afford to pay for (Credit cards allow you to live over and above your means for a while). Then he would ran up a bill that he couldn't afford to pay anymore. (Read Ramit Sethi's brilliant book I'll Teach You to be Rich to know more)

If my friend hadn't listened to me, he would have reached the conclusion that using a credit card is the worst thing that could have ever happened to him. Let's change that sentence. Using credit cards to fund an extravagant lifestyle when you don't have enough money to sustain it. Well credit cards are not really meant to be used that way. Ramit Sethi uses brilliant examples in his book I mentioned above.

The fault is with consumer loans. They bear exorbitant interest rates. And add to that the interest/charges recovered by the credit card companies. My friend finally understood his folly when i sat him down and explained the above process with a gun to his head (I was just yelling at him). Loans that are not productive or essential to fund a purchase don't make sense. They just end up burning a huge hole in our pockets. And remember, all your credit history gets recorded by the credit bureaus like CIBIL. In the future when you approach a bank or financial institution for a loan, he or she can see exactly credit behaviour. That is they can see that you have a habit of buying consumer goods using high interest bearing loans. This is seriously risky credit behaviour. Your credit card is also a loan, not an ATM.

ATM withdrawal charges and payment banks

It has been a very interesting past few weeks. The RBI has taken two regulatory actions that are very interesting. First, it has allowed banks to charge their customers for use of ATMs over a threshold limit of transactions. It has also capped the amount that can be charged per transaction. We've had few of our biggest banks following this with charging their deposit holders money to withdraw cash from their ATMs from November above 5 transactions in metros. (Non metros your turn will come). Second, we've also had the RBI releasing the final guidelines for payment banks.

These two actions by the banking regulator are quite schizophrenic at first. One initiative allows banks to fleece their customers of more charges in the name of 'third class' service. The second tries to perform the Prime Minister's dream project of financial inclusion. Then why are banks wanting to charge their customers to withdraw money, when we are still struggling with inclusion?

I've been grappling with this question till I had my eureka moment. So we need financial inclusion. What's the solution to that? The Pradhan Mantri Jan Dhan Yojana apparently seems to be taking care of that. This will basically be used to route all the government doles and funding to our less fortunate citizens, who usually have to fend for themselves. It's basically laying the ground work for people to only transact through the official banking channels.

Banks usually collect deposits from their customers to transact their business. This can be done through Term Deposits or CASA. A lot of Current And Saving Accounts (CASA) are cheap funds for banks. They use that to fund their lending business. Someone called it lazy banking. But banks are not gonna have the available balance in the 'Jan Dhan' accounts for them to be profitable. Hence, they need to charge other customers money for hitherto free services like ATM withdrawals. 

This has its origin when the RBI allowed banks to unbundle their services. Remember the first time you found out that you require to pay a charge for an NEFT transaction? (Yes it was free for a while). That was the beginning of this phase of further unbundling of services. Now banks charge you for even breathing the air inside the bank. No, that's not true. But that's how banks function. They need to create different lines of businesses. No business can survive by only having a few lines of businesses. This diversification, within the construct of traditional banking, is what leads us to banks charging you even for a statement of account that one would require from the banks' branch.

Why is this a good thing?

Alright, the title sounds deceptive. Am I advocating that banks fleece their customers? Hell no! But people have to be smarter to realise what's the real game that is being played by the regulator. It wants to streamline the financial system so that all the transactions are captured within the control parameters of the financial system. This can never be done if we have a parallel cash economy that may or may not be funded by fake currency notes. So levying charges on people for cash withdrawals will lead them to use cash sparingly. But never under estimate the Indian mind. We haven't been used to ATMs for that long. So we might as well find people queuing up at cash counters to hoodwink all the well laid out plans.

Anyway, the establishment of payment banks will add to the aforementioned action. Payment banks basically take money as deposits and invest them in approved securities which don't have inherent risks of default. This basically means that if I am ready to invest up to ₹1 lakh in a deposit, I will get interest on it from a savings account with a payment bank and there will be less of a risk on that amount not being repaid to me. 

How does this work together with the charges on ATMs? Well, even companies which provide an online wallet service can become payment banks as per the guidelines of the RBI. This means companies like PayTM, Airtel(m-pesa), Vodafone etc. Basically, everyone who operates an e wallet facility. Better still, they will have to pay you interest on the money you've deposited. So, you'll have money stashed in a wallet that you can call for whenever you need to make a payment and as a result, this will lead to reduced use of cash. This achieves the RBI's objective of getting all financial transactions within the financial system. And tadaa! The apocryphal 'kala dhan' is firmly under the financial system's watch. 

It'll take its time, but these measures in tandem will lead people to sparing use of cash And that will help in controlling the uncontrollable, the generation of unaccounted money in the system.  Regulatory actions sometimes appear to favour a few, but the real picture only appears when the dust settles.

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