Accounting scandals are spoiling Indian banking system’s credibility

Corporate cons like the Nirav Modi scam, unbelievable rise in non-performing assets (NPAs), new provisions like bail-in under Financial Resolution and Deposit Insurance (FRDI) regime are a multi-pronged conspiracy aimed at weakening India’s largely public-owned banking system. This would result in corporate appropriation of public savings besides diverting household savings into speculative investment to fuel market bubbles. Thus, the Nirav Modi scam is not an unusual.

Domestic savings, domestic investment and domestic market are the three pillars of Indian economy and were mainly responsible for largely insulating it from the contagion effect of global financial crisis. The banks account for 70 per cent of India’s household savings, indicating the credibility they enjoy. Public sector banks, account for a big share of these household bank savings. Thus, the public ownership of India’s financial system greatly contributed to the stability in India’s banking system despite problems of work culture and associated nuisances.

Well, India is not new to financial scams, but every time just a person or the banks are targeted; but no one questions the accountant or the auditor. Auditors are supposed to act as gatekeepers to protect the integrity of Indian markets; but in most of the cases, they failed to live up to their professional obligations. If given the vast scale of recent accounting scandals and their devastating effects on workers and investors, it’s not surprising that the government and the public assume that the underlying problems are corruption and criminality — unethical accountants falsifying numbers to protect equally unethical clients. But that’s only a small part of the story. Serious accounting problems have long plagued corporate audits, routinely leading to substantial fines for accounting firms.

Some of the errors, no doubt, are the result of fraud. But to attribute most of the errors to deliberate corruption would be to believe that the accounting profession is widespread with black hats. In deep, the more pernicious problem with corporate auditing, as it’s currently practiced, is its defenselessness to unaware bias. Because of the often subjective nature of accounting and the tight relationships between accounting firms and their clients, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company’s true financial status, thereby misleading investors, regulators, and sometimes the management. Indeed, even seemingly egregious accounting scandals, such as Andersen’s audits of Enron, may have at their core, a series of unconsciously biased judgements rather than a deliberate program of criminality.

Rooting out bias, or at least tempering its effects, will require more fundamental changes to the way accounting firms and their clients operate. If we are really going to restore trust in the Indian system of auditing, we will need to go well beyond the provisions of the IT Act. Only then we can be assured of the reliability of the financial reports issued by public companies and ratified by professional accountants.

Moreover, when we are striving to reach a particular decision, we usually tend to critically analyze and then discount facts that contradict the conclusions we want to reach, and we uncritically embrace evidence that supports our positions. Unaware of our skewed information processing, we erroneously conclude that our judgments are free of bias. Professional accountants might seem immune to such biases. But the corporate auditing arena is a particularly fertile ground for self-serving biases.

Auditors have strong business reasons to remain in clients’ good graces and are thus highly motivated to approve their clients’ accounts. Under the current system, auditors are hired and fired by the companies they audit, and it is well known that client companies fire accounting firms that deliver unfavourable audits.

Even if an accounting firm is large enough to absorb the loss of one client, individual auditors’ jobs and careers may depend on success with specific clients. Moreover, in recent decades, accounting firms have increasingly treated audits as ways to build relationships that allow them to sell their more lucrative consulting services. Thus, from the executive team down to individual accountants, an auditing firm’s motivation to provide favourable audits runs deep. As the collision case also showed, once people equate their own interests with another party’s, they interpret data to favour that party.

An audit ultimately endorses or rejects the client’s accounting — in other words, it assesses the judgements that someone in the client firm has already made.

These auditors displayed role-conferred biases in two ways. First, their valuations were biased in the clients’ favour: The sellers’ auditors publicly concluded that the firm was worth more than the buyers’ auditors said it was. Second, and more tellingly, their private judgements about the company’s value were also biased in their clients’ favour.

The key to improving audits, clearly, is not to threaten or cajole. It must be to eliminate incentives that create self-serving biases. This means that new policies must reduce an auditor’s interest in whether a client is pleased by the results of an audit.

True auditor independence requires, as a start, full divestiture of consulting and tax services. And even then, a fundamental problem will remain — because auditors are hired and fired by the companies they audit, they are in the position of possibly casting negative judgments on those who hired them — and who can cut them loose. Therefore, even with the elimination of consulting, the fundamental structure of the auditing system virtually ensures biased auditing. Current legislation requires auditor rotation; however, this is defined as a change in the lead partner within an auditing firm. There is no provision to rotate the firms conducting the audit, and there is no provision to prevent a client from firing an auditor. Thus, auditors will continue to have powerful incentives to keep their clients happy.

Well! Top executives cause not all accounting scandals; often managers and employees are pressured or willingly alter financial statements for the personal benefit of the individuals over the company. Managerial opportunism plays a large role in these scandals. For example, managers who would be compensated more for short-term results would report inaccurate information, since short-term benefits outweigh the long-term ones such as pension obligations.

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