IL&FS crisis: How did the auditors, rating agencies remain silent spectators even as the ship was sinking

A black humor having its origin in the medical world is: Operation successful, patient dead. Much the same has been witnessed over the years in the more rarified world of corporate accounting and finance.It is customary for the auditors to pronounce in inscrutable dense accounts-speak that everything is hunky-dory with a company’s accounts subject to numerous qualifications even as its financials are in a shambles.The qualifications defy comprehension and often quantification as well so much so that even if they have the effect of converting a seemingly prosperous company into a losing one, the message is lost except on the cognoscenti. And this farce has been going on for ages on the self-serving ground that the statutory auditor signing the annual accounts and the related audit report is concerned only about the truth and fairness of the accounts and not about their ramifications.

Who then is responsible for reporting the financial mess and rot? Well, it is supposed to be the internal auditor who is often the handmaiden of the management.

A lot was expected of the independent directors in whom the SEBI has immense faith but they have never risen to the call of their duty. Thus the can gets kicked around with shareholders and investors remaining bemused.[caption id="attachment_5309041" align="alignleft" width="380"]

Representational image. Image courtesy: IL&FS[/caption]Despite the looming and overbearing presence of marquee shareholders such as the Life Insurance Corporation of India (LIC) 25.34 percent stake, State Bank of India (SBI) 6.42 percent stake, Central Bank, HDFC, PPF and Orix Corporation, IL&FS seems to have run amok.The conduct of operations through a labyrinthine structure of over 130 subsidiaries compounded by opaque financial reporting that effectively hid liabilities and mind-boggling top managerial pay and dividend payouts amid mounting losses has been the story of brazen financial engineering and accounting by IL&FS.The government’s concern is IL&FS is too big to fail in the sense banks have a huge exposure of Rs 55,000 crore to it out of its total outstanding liabilities including to bondholders of Rs 1,15,000 crore.The government is right to supersede the board of IL&FS given the large size and exposure of insurance, mutual funds and provident funds to IL&FS. Its default to banks would trigger a contagion of bank collapse reminiscent of the Lehman Bros collapse in the US in 2008. That is why the government has superseded its board and anointed knights in shining armour led by the redoubtable Uday Kotak, founder of Kotak Mahindra Bank to salvage as much as possible.

Fortunately for the creditors, the haircut need not be very high as IL&FS reportedly has assets worth Rs 91,000 crore.

This fortuitous situation is akin to the fortunes of the stakeholders in Kingfisher Airlines case. The erstwhile liquor baron, Vijay Mallya’s assets seized by enforcement authorities estimated to be worth Rs 13,000 crore is perhaps enough to pay off bank dues as well as taxes and employees’ dues.In that sense the pro-term board does not have a very difficult task because IL&FS at the end of the day is not as much about loot and diversion of funds as it is about asset-liability mismatch (ALM) and seeking to grow at a frenetic pace. Its short-term deposits are locked up in long-term loans to infrastructure companies, with some of them being IL&FS’ own subsidiaries in what can be called worst conflict of interest situation.The government has been prescient in acting against labyrinthine subsidiaries with the law taking effect from 20 September 2017 coming down heavily on multi-layered subsidiaries. A company can at best have two layers. In other words, company A can control company B directly and control company C through company B. Period. But this rule is prospective. IL&FS has gotten away with opaque multi-layering in an era of slack control over creation of mushrooming subsidiaries that concealed more than it revealed.IL&FS is also a saga of collective and all-round failure of oversight.

Rating agencies rated its bonds in superlative terms only to downgrade them when it was too late; independent directors looked the other side or were simply out of their depths; mutual funds did shoddy research before sinking unit holders’ investments and auditors couldn’t care less.

It is the auditor whose role always comes into question when a scam or mismanagement unfolds. Audit failure starts with the way they are appointed and ends with the way they report. Both must change. A company management should not have the luxury of choosing its own auditor. The auditor should be an unknown quantity which is possible only when there is periodic rotation of audit firms from out of a large panel of auditors a la the audit of public sector units (PSUs).Under the extant arrangement, an auditor cosies upto the management incestuously as he is beholden to it for the favor of cherry picking him. Once the appointment regime is thus sanitised, he must be compelled to report all negative ramifications including conflict of interests and financial skullduggery. The ALM and non performing assets (NPA) -- the two bugbears of our banking system for example, never figure conspicuously in bank auditors’ report. It is time the government wrenches away the we-are-watchdogs-not-bloodhounds alibi from auditors.Consolidated accounts of holding and subsidiary companies must be the norm so that the auditor gets a holistic look into the holding company and its babies. The law must mandate that the auditor of the entire group is the same. Forensic audit may not be possible by auditors but they must be mandated to call in the investigators like the Serious Fraud office or the Central Bureau of Investigation (CBI) or the income tax authorities or the Enforcement Directorate (ED) as the case be when they smell something fishy. Otherwise they must be hauled over the coals.(The author is a senior columnist and tweets @smurlidharan)