CORPORATE ACCOUNTABILITY AT CROSSROADS

Shri A. Prasad

When I joined the Indian Railway Accounts Service in 1963, it was a widely held perception that a finance executive is about the only one in the organization who has the credentials to be its “Conscience-keeper”. This image was predicated on the fact that he was the only one neither involved in “empire-building” nor interested in any other hankie-panky. In fact, his whole and sole concern was the bottom line of the organization which if healthy, would benefit all without discrimination and if not healthy, would deprive everybody the same way. This naturally gave to the Finance Executive an aura of invincibility, somebody who could do no wrong and somebody who would invariably blow the whistle if others tried to do anything wrong. It is a moot point whether in the Indian context despite Mehtas and Dalals wreaking havoc on the stock market, the perception of a Finance Professional as the conscience keeper has or has not suffered. I leave this issue to be decided by the reader. But what is clearly visible to the naked eye is that in the international context, the image of a finance executive as a “no hankie-panky-no nonsense” person has taken a fair amount of beating, thanks to the bizarre incidents to which we turn in the succeeding paragraphs.

In recent years we have witnessed some extraordinary events causing a rude shock to the “Conscience-keeper” image of not only the Finance Executive, but in fact the whole apex team of corporate governance. These events have brought out the general issue of accountability in corporate governance in a much sharper focus.

The most significant episode was that of a giant company like Enron going under “Titanic” style, and an equally large and reputed auditing firm like Arthur Andersen getting indicted for its culpability in Enron episode. Equally significantly, “Global Crossing”, a telecom company, valued at $50 billion (incidentally, audited by the same auditors, Arthur Andersen), evaporated almost the same say. As per newspapers reports, in both cases senior company insiders sold millions worth of shares, leaving the employees and even their pension, completely in the lurch. As if to complete a hat-trick, news came in June, 2002 that another giant telecom operator, World com had uncovered improper accounting for almost $4 billion in expenses, raising bankruptcy fears and further shocking investors already reeling from accountancy scandals.

It is a matter of anguish that in a country like U.S.A. which prides itself as the bulwark of capitalism and free enterprise and lays great emphasis on responsible, responsive and “value-based” management principles, companies like G.E. and Xerox were under a cloud. There were also reports that the analysts of Merrill Lynch, a Wall Street mega start were found misleading investors into buying stock that they personally believed, were junk, apparently due to conflict of interest between the firm’s research division and its investment banking operations. No wonder that the capital market in the U.S.A. remained in a state of shock and turmoil for quite sometime, leading to the commencement of the downward journey of the dollar which continues even today.

What message do we get from these events? It is no small comfort that for a change, not many in U.S.A. and other countries are giving excuses for what happened or for that matter holding a brief for the offending parties. Instead, intellectuals, professionals and institutions are working hard to discover chinks in system, procedure, practices, and legal provisions which need to be plugged to ensure greater corporate accountability and to protect the interests of hapless small investors.

If this is what has been seen to have happened in so many cases in the U.S.A. where they have an elaborate peer-review as also regulatory oversight by a Public Oversight Board, how safe are we in our belief in India that there is nothing much to worry about? Do these episodes hold some lessons for India? Though ICAI has now mandated that every member would have to undergo peer review starting April 1, 2003, is it going to be enough considering that it has not been found effective in U.S.A.? Moreover, the issue of Public Oversight Board has not even been considered in the country, and even if it is considered, would it be possible to structure an effective regulatory mechanism in India where a majority of auditors of corporate India are small to medium type enterprises or even small partnership firms?

How did it happen in Enron?

In a global trading company like Enron, accounting can be a very complex phenomenon even to those who are ordinarily knowledgeable. But it is accounting which really holds a clue to how the company fell so fast, taking with it the jobs and pension savings of thousands of workers and inflicting losses on millions of individual investors. The story can be reconstructed on the basis of information available on the internet. According to Time magazine, the heart of Enron’s demise was the creation of partnerships with shell companies, many with names like Chewco and JEDI, inspired by star wars characters. These shell companies run by Enron executives who profited richly from them allowed Enron to keep hundreds of millions of dollars in debt (some reports suggest about $500 million) off its books. But once stock analyst and financial journalists heard about these arrangements, investors began to lose confidence in the company’s finances. The results: a run on the stock, lowered credit ratings and insolvency. Enron officials have acknowledged that the company had overstated its profits by more than $580 million since 1997.

According to News Hour (on line) of January 22, 2002, the key to Enron’s success in fooling the world was what you might call “accounting alchemy, miraculously turning lead into gold, water into wine, losses into profits, making debts and bad investments, or anything they wanted, to simply disappear. Or to put it differently, Enron played the all-in-the-family fantasy finance game, manipulating hundreds of subsidiary companies with names out of Star wars, Jurassic Park”.

The same article describes the events as follows(To quote) “Now, a key to this Scam was perhaps Enron’s main alchemical tactic; The use of its so called related parties companies like Raptor or Brave heart, companies created and owned almost entirely by Enron; subsidiaries, really, some of them run by its Chief Financial Officer. Yet, when it suited Enron’s interest, these related parties were treated as independent, arms length businesses.

In the case we just heard about, another related party had invested in something called New Rhythms net connections. This is our fanciful representation of it (Beethoven’s Ode to Joy, playing). Unfortunately, New Rhythms had crashed. So Enron entered into something called a derivatives contract with its own subsidiary. The contract increased in value and New Rhythm’s stock price went down.

So if the stock rose, Enron would report profits from the stock because it was an asset of the subsidiary. If the stock dropped, Enron would report profits from the new Rhythms derivative contract, neglecting to report that the related party-the subsidiary- was losing exactly the same amount.

This is like me claiming my daughters have a separate company, which lost $100 million in an internal stock, but I made $100 million on the deal because I had contract with them where they had to pay me a dollar for every dollar they lost. Meanwhile, who would make good their debts to me? Me, their father.

Bottom line: I lose $100 million, but report it as a $100 million profit, which is exactly what Enron did when the stock, in fact, tanked (unquote).

Issues which need to be considered in a broader perspective

The downfall of Enron as indeed other companies named in this article is being seen as the failure of accounting standards, auditors, regulatory system and regulators. Let us examine and analyze each of these headings and see what precautions/reforms are needed in the global as well as Indian context.

Accurate company accounts are a key to the success of capital markets anywhere in the world, the more so in the U.S.A. where capitalism is expected to redistribute wealth aggressively and therefore the system has to have trust, transparency and accountability. While a deliberate act of deceit may nevertheless take place even in the best of circumstances, the real issue is whether sufficient checks-and-balances exist to make it difficult for the dodgers of the rules to do what they wish to do. With whatever information we have been able to lay our hands on, the American system in this regard does not seem to be anywhere near invincibility. Rather it has loopholes which can be taken advantage of by a bad management hell-bent on preparing misleading accounts and auditors ever ready to oblige them. In a way it can be stated that accounting standards both in the U.S.A. and in the rest of the world have generally failed to reflect a blurring of corporate boundaries caused by the proliferation of partnerships, joint ventures and outsourcing etc. They have also failed generally to report and capture the emergence of new kinds of assets (mostly intangible) and liabilities (off-balance sheet financing, derivative contracts, etc.). Enron is not the only case. Several dotcom and technology companies have used “creative” and “aggressive” accounting to artificially boost earnings. Many companies have got away with “proforma accounting” which delivers nice numbers by omitting such items as stock write-offs, special transactions, interest charges or depreciation. In the context of Enron, let us take just two specific examples of this kind of creative accounting and see where we stand in India.

i) Whether business can, and should be conducted off the books as in the U.S.A. or whether there should be an appropriate system of consolidation of accounts.

ii) Whether accounting standards regarding treatment of investments need to be re-examined and modified.

As regards issue (i) above. Mr. Sharav of the Colombia Business School in New York has been quoted as saying thus: “Look high and low in any accounting textbook’s indexes; you won’t find any references to special purpose entities”. Even with regard to the issue of consolidation of accounts, principles and practices differ. Let us briefly examine these variations. While there can be no consolidation of the accounts of partners as they are separate legal entities; even in respect of subsidiaries, the Indian Companies Act does not require consolidation of their accounts with that of the parent company. However, the Act, provides that the financial statements of subsidiaries should be attached with the main balance-sheet of the parent holding company. The Indian Accounting Standards are even less stringent in this respect. They do not even call upon companies to attach statements of accounts of subsidiaries with the main balance-sheet of the parent company. In the United States, the provision in respect of subsidiaries is that accounts of subsidiaries have to be consolidated but they do not make any mention of what treatment should be given to investments in partnership entities.

In a listed company, mere attachment of statement of accounts of subsidiaries may not provide enough guidance to the common investor as to the financial health of the parent/holding company. In a majority of cases the small investor will not have enough knowledge of accounting issues to rummage through a volume of data in the attached accounts of subsidiaries and come to some meaningful conclusions about the financial health of the company. Therefore, it is better that both the Companies Act and the Indian Accounting Standards, acting in concert, provide for consolidation of accounts of subsidiaries into the accounts of the parent/holding company. Consolidation is in fact the only way to present a complete and unambiguous financial picture of any large organization which has spread its wings in many directions.

Coming now to issue (ii) above, viz status of investments in partnership firms, something which led to downfall of Enron and severe indictment of Arthur Andersen, there is a conflict between the Indian Companies Act provision which requires such investments to be shown at cost or market value (in effect giving a choice to the company to chose one of the two which proved fatal in the case of Enron) and the Indian Accounting Standard which does not require the investing company to show the status of investment in the partnership firm at all. The position in the U.S.A. is similar to the Indian Accounting Standards, a loophole which was apparently taken advantage of by Enron. Considering what might happen if this loophole is not plugged, it would appear necessary to prescribe that the status of investments in partnership firms (or special purpose entities as Enron called them) should be reflected in the balance-sheet of the investing company. In addition, the effect of that investment on the finances of the investing company should also be explained by way of a footnote on the basis of costs or market value, whichever is less. Of course, a knotty question is how to determine market value as all these investments need not necessarily lend themselves to easy determination of market value with reference to known yardsticks, e.g. prices in the stock market, etc. But a conservative approach would be a lot better than an open invitation to fraud with or without the connivance of auditors. This will help the small investor to take an informed decision about his investment options.

Auditors and their so called independence

The “Independence” of auditors right from the appointment to their removal is a must if we wish to put a stop to “creative” accounting practices often indulged in by managements to boost their earnings etc. In India auditors are initially appointed by the board of directors. All subsequent appointments are made in the Annual-General meeting by a simple resolution. The general practice in private sector companies has been to continue with the same auditors for decades. In due course they tend to develop vested interests and conduct themselves more as employees of the company beholden to the management rather than independent auditors whose unbiased and professional approach should provide right guidance to the management and shareholders both. On the other hand in Government Companies, the auditors are appointed on the recommendations of the C&AG usually for a fixed term of 3-5 years and there is in-built rotation in the system. Now that many blue-chip Government companies have been privatized and private companies have to play a major role in keeping the capital market healthy, the issue needs serious deliberation whether auditors in private companies should be appointed for not more than 3-5 years at the end of which there should be compulsory rotation.

Auditing is a professional function and auditing firms have all been presumed to have attained the same standard. Therefore, except for reasons which may be of dubious value, there is no need for pick-and-choose on grounds of professional competence. It is, therefore, worth a consideration whether for private companies as well, the C.A.G. or the ICAI can be given the responsibility to suggest to the board of directors a panel of names out of which the company may select the auditor for a period of say, 3 to 5 years.

A linked issue is payment to auditors by companies for services other than audit with same company. In India, according to Companies Act, an auditor may receive separate remuneration for services other than audit work, e.g. advising on taxation maters, writing up the accounts, etc. Such remuneration does not require sanction of the general body. However, a separate disclosure of all amounts paid to the auditor in whatever capacity, is required to be made with P& L Account.

There should be a ban on audit firm’s offering (often more profitable as in the case of Enron) consulting and other services to their audit clients. The Economic Times in its editorial in the issue of 30.05.2002 has rightly commented that it is essential to have Chinese walls between the audit and consultancy arms of an audit firm. Independent auditing and independent credit and stock rating agencies are a part of the Central nervous system of capitalism and free market. They provide the checks and balances so crucial for the smooth functioning of the system. Let the so called “independent” auditors not be “dependent” on the companies they were auditing.

Regulation of Auditors

Even in a country like the U.S.A. which has both self regulation through peer review and oversight by professional bodies, review is more a fiction rather than reality. One can therefore imagine what must be happening in India. Here, there is practically no oversight by a third professional body and issues such as segregation of audit and consultancy is not being discussed pointedly enough. It is therefore desirable that following issues are discussed in depth and appropriate decisions arrived at:

i) Whether there should be a ban on payment by a company to its auditors for services other than audit.

ii) In the event of the above being considered too drastic, whether services other than audit which can be rendered to the same company, may be specified and remuneration for these services so fixed as not to exceed a certain percentage of the audit fee;

iii) Such remuneration and the type of services to be rendered other than audit may also be approved by the General Body and form a part of the Directors’ Report.

Conclusions

Rudi Dornbusch, a Ford Professor of Economics at M.I.T. and a former Chief Advisor to the World Bank has in an article commented tellingly that capitalism as a system will not take roots around the world if corruption defiles it. It cannot, and should not, be seen as a system that works for insiders and their cronies, such that it is perceived as rigged. The system involves a delicate problem of agency and trust. Capitalism is a public trust. It works if everybody has a fair chance and corporate theft receives highly visible punishment to individuals who have perpetrated it. We in India have time and again witnessed now familiar pattern of rigging and unethical practices, and it will take the country decades to get over the perfidy of Harshad Mehta affairs, Ketan Parekh episode, U.T.I. debacle and many others. Therefore, following steps appear imperative:-

i) A high power multi-disciplinary group needs to go into the entire gamut of Indian Accounting Standards and requirements under the Companies Act to see what loopholes exist and what modifications are required on the basis of proven and best possible international practices (some examples have been given in this article).

ii) Rules and practices regarding appointment of auditors, their tenure, issue of rotation, remuneration and entrustment of work other than purely audit work to the auditor by the audited company need to be deliberated upon by the same body.

iii) The question of regulatory framework for audit firms and the most effective way of doing it may also be gone into by the same group. Among other things the group will have to consider how in the typical Indian environment of existence of very small audit firms and partnerships, the requirements of the system can be harmonized with the cut-throat competition for survival that they are engaged in.

(The author is retired Member (Finance), Telecom & ex-officio Secretary to Government of India. He also headed the National Institute of Financial Management, Faridabad from early 2001 to early 2003)