To give you some background on this post, last week I had disagreement with a celebrated financial expert about the ethics of preparing financial statements. It started with me saying this

– “if the management does not want you to know something about the accounts, you will not know it. Period.”

There is a thin line between manipulation of financial statements and doing what you are legally allowed to do. What blurs this line even more is creative accounting of the kind which can almost never be discovered by those who are not aware of certain facts. Let me explain this with a real life example.

Example

This happened a few years back when I was working as a capital markets attorney. Typically a capital market attorney’s job is to conduct diligence for companies who are planning to raise money by equity divestment in any way. They are to question not only the management but also their auditors with respect to certain things which come to their attention in the process of looking through accounts.

In this case the company had advanced ‘earnest deposits’ to many developers to get a feasibility report for the construction of various commercial real estates. Ideally, these deposits are either adjusted against the construction costs once the projects start or they are returned by the developers (after deducting 2%) in case the project is not feasible or if it does not take off for any reason.

In 24 cases these ‘earnest deposit monies’ did not come back for many months, nor did any of these projects start.

When this was brought to the attention of the auditors, it was felt that they should classify these deposits as ‘doubtful debts’. This would have had devastating consequences on financial statements in the short term. Most importantly, the immediate terms profit and loss account would take a hit by the entire amount classified as ‘doubtful’ resulting in a huge loss.

Note: As per the Indian Accounting Standards, auditors have complete discretion as to when they classify an entry as doubtful. While most auditors take a cut off at 12 months after which they classify an advance as doubtful or make provision for it, in case interest is not being paid on such account or where as in the above case, such deposit neither comes back nor gets utilized for the intended purpose.

Naturally, the management would be completely against showing a big loss just before it files its offer document for an IPO.

Solution?

You push the auditor to not classify this as a doubtful debt just as yet, at least for another 3 months. After all he has complete discretion on this matter. In 99 out of the 100 cases, auditors tend to agree. The ones who do not agree are usually fired and the new auditor then agrees to exercise his ‘full discretion’. Either way, like in the above case, in most cases financial statements continue to look good and bad as per company’s desire.

One may question what attorneys and lawyers do when they find out about such things.

Two things here –

First, they usually insist on putting a risk factor in the document. Something like:

“The company advances certain earnest deposits to study feasibility of projects from time to time. As of the date of filing this document the company has advanced an amount of Rs. XXXXXXX for such feasibility reports. These deposits are unsecured and in case any or all of these deposits do not come back, it could have a negative impact on company’s financial condition and results of operations. Consequently the stock prices could go down.

Second, just like the auditors, attorneys also get paid by the issuer company. So do investment bankers and anyone else who assists the company in their capital raising exercise.

Who Should Be Blamed for Manipulation of Financial Statements?

As you would sense based on the example above – often it is a concerted effort of all parties involved to get creative with accounts. This was just one extreme example of things which you will not discover in the short term and I don’t care how good you are, you will not discover it unless you have a strong sense of premonition.

Nevertheless, there are cases where much worse gets done with. It’s appalling!

Unless service providers like attorneys, chartered accountants and investment bankers are paid by someone other than the issuer company this problem will remain i.e. this problem is likely to remain forever.

So who do you blame? Anyone who thinks he is doing something he should not be doing is to be blamed.

The world of course is not as principled as I hoped it would be when I was younger. Nevertheless, if I had to fix blame on any one party it would have to be the accountants and may be to some extent, the auditors. Before I discuss my reasons let me talk a little about the difference between accounting and auditing. I see many people confusing the role of an auditor with that of an accountant.

Accounting Vs Auditing

The job of an auditor starts from where the job of an accountant ends.

The internet is filled with articles which lay out the difference between auditing and accounting. For the purpose of this article I will focus on only one thing – Who authenticates the financial statements?

As you may or may not know, the job of an accountant is to prepare the accounts like the profit and loss, balance sheet, cash flow statements etc. This is done by internal accountants who are on the payrolls of the company. Preparation of accounts is based on data collected throughout the year. It involves aggregating vouchers and receipts to record the total amounts under each head such as ‘total income’, ‘total expense’ etc.

Keep in mind that a big company will have accounts departments in many cities and a main accounts office where all reports are sent for final compilation. Auditing on the other hand is the process of verifying entries by a process called ‘vouching’ – inspecting of documentary evidence which supports the financial numbers as presented by the internal accountants of the company to the auditors.

What Falls on the Difference?

Both, accountants and auditors have similar qualifications (usually both are chartered accountants in India). Hence they work based on the same set of principles. Practically an audit only serves as an additional tool to check the veracity of accounts prepared by the internal accountants of the company.

A typical auditor’s report will have a mitigating disclaimer worded somewhat like this (signed by both – the management and the auditors):

Management’s Responsibility

The Company’s Management is responsible for the preparation of these consolidated financial statements that give a true and fair view of the consolidated financial position, consolidated financial performance and consolidate d cash flows of the Group in accordance with the accounting principles generally accepted in India. This responsibility includes the design, implementation and maintenance of internal control relevant to the preparation and presentation of the consolidated financial statements that give a true and fair view and are free from material misstatement, whether due to fraud or error.

Auditors’ Responsibility

OUR RESPONSIBILITY IS TO EXPRESS AN OPINION ON THESE CONSOLIDATED FINANCIAL STATEMENTS BASED ON OUR AUDIT. We conducted our audit in accordance with the Standards on Auditing issued by the Institute of Chartered Accountants of India. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.

There is some merit in this disclaimer as it may not be feasible for an external auditor to verify each expense item by looking at a voucher or a bill to support every entry. That is something which necessarily has to be done by internal accountants working with the company on a full time basis. In spirit, this disclaimer should be taken as “a disclosure that We as auditors have made best efforts to verify the accounts in the process of making them compliant with  the accounting standards in India.

In 100% of cases when companies (big and small) get embroiled in financial frauds, it is found that they were hiding things for years together and disclosed stuff when things could either not be repaired; or disclosed much after the business ceased to exist.

Let me end this by repeating what I said before – you may be the best forensic audit expert out there, but if the management does not want you to know something, you will not know about it. At the very least, on a quarterly basis, management will continue to hide things behind accounts.

Yet another reason why you should give preference to integrity of management over financial position.