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Accounting jugglery

| Updated on August 18, 2019 Published on August 18, 2019

A string of cases involving accounting sleight of hand and auditor negligence has come to light in recent times. But this is not new. Over the years, companies have used various methods to stretch the financial numbers to mislead investors and other stakeholders. We look at five cases

IL&FS: Loans evergreened

Parvatha Vardhini C

What seemed a liquidity crunch in certain companies in the IL&FS group a year ago, has metamorphed into an accounting fraud and has had ripple effects across the NBFC sector since then. The saga began in June last year when IL&FS Transportation Networks (ITNL) delayed repayment of ₹450 crore of inter-corporate deposits from SIDBI.

In August 2018, IL&FS Financial Services (IFIN) defaulted on repaying its commercial-paper investors on the due date. As news of more delays/defaults came to light, rating agencies downgraded the group’s various borrowing programmes to junk status, affecting mutual funds, banks and insurance companies with exposure to the group and, ultimately, retail investors.

Over the last few years, companies such as IFIN had raised funds from the market and issued new debt to clients/group companies to help them service old debt. These entities were otherwise finding it difficult to do so due to such reasons as project cost-overruns. This process helped the group postpone provisioning for bad loans and/or recognition of NPAs, enabling them to show good profits.

But there came a point when things went out of control as asset-liability mismatches arose from using short-term borrowings to fund long-term infrastructure assets. When the crisis broke out in September 2018, the IL&FS group, comprising over 300 entities, stood on a consolidated debt of nearly ₹1 lakh crore — ₹99,354 crore to be precise. Its debt-to-equity ratio was 10:1 as of March 2018.

Under the lens

A probe ordered by the Ministry of Corporate Affairs in public interest brought out a charge-sheet in end-May 2019. The Serious Frauds Investigation Office (SFIO), which conducted the probe, found that IFIN fraudulently lent to different companies belonging to a defaulting borrower (non-group entities) to help them repay their principal and/or interest, repeating the cycle several times.

Ultimately, the final loan was declared NPA or written off or is still outstanding, resulting in delayed recognition of NPAs, ballooning of debt and ultimately, losses to IFIN and its stakeholders.

Lending multiple times over was also carried on with group entities. In doing so, IFIN disregarded RBI norms for group lending to help the holding company (IL&FS), which had reached its lending limits.

Lending by IFIN to group companies stood at ₹5,200 crore or 37 per cent of total loans and advances for the year-ended March 2018. Besides, group entities such as ITNL were supported by lending through vendors and third-parties as well, who immediately transferred the funds to ITNL or ITNL SPVs.

Though these actions led to negative net-owned funds (NOF) and negative capital-to-risk weighted assets ratio (CRAR) at IFIN, auditors did not raise the red flag. They also did not exercise due diligence in verifying end-use of funds and were found guilty of colluding with the management to conceal material information and falsifying books and financial statements from 2013-14 to 2017-18.

To resolve the crisis, the new board appointed after the NCLT order on this matter has embarked on asset monetisation and sale of investments across companies in the group.

Satyam Computers: Fudged figures

On January 7, 2009, Ramalinga Raju, the Chairman of Satyam Computer Services, dropped a bombshell. He confessed that the company’s accounting books were fudged. The news sent shock waves. Satyam Computers was among India’s big four information technology companies. This was possibly the biggest scam in Indian corporate history, and was referred to as India’s ‘Enron’.

Surprisingly, the accounting tricks employed were fairly simple — inflate revenues and profits, overstate assets, understate liabilities. This made it all the more surprising as to how Satyam’s auditors (PwC) missed out on what was going on for years.

How big was the hole?

According to Raju’s statement, Satyam Computers’ September 2008 balance-sheet had inflated cash and bank balances of ₹5,040 crore, non-existent accrued interest of ₹376 crore, understated liability of ₹1,230 crore and overstated debtors position of ₹490 crore. All this added up to ₹7,136 crore.

The gap in the balance-sheet, Raju said, was due to inflated profits over many years. In the September 2008 quarter, for instance, revenue was shown as ₹2,700 crore as against the actual ₹2,112 crore, while operating profit was shown as ₹649 crore against the actual ₹61 crore. This resulted in cash and bank being inflated by ₹588 crore in the September 2008 quarter alone. The company’s operating margin for the quarter was just 3 per cent as against the reported 24 per cent.

This pattern of inflating sales and profits had been going on for many years. The need to keep up with the pretence of higher profits caused the company to invest more in resources and assets, which resulted in costs going up significantly.

The promoters feared that a poor financial performance would result in a take-over which would expose the hole in the books. So, the vicious cycle of falsification of accounts to cover up earlier falsifications continued. As Raju put it, “It was like riding a tiger, not knowing how to get off without being eaten.”

Giving effect to financial frauds involves many carefully co-ordinated sleights of hand at the operational level. So, there was excess billing through fake invoices; non-existent employees were shown as being on Satyam’s rolls, and fixed deposit receipts were forged to give credence to the purported bank balances.

If the auditors had done the basic audit check of confirming with the banks the balances held by Satyam, the fraud could perhaps have been sniffed out earlier. Failing to do this raised suspicions that the audit partners were negligent, at best, and complicit, at worst.

Accounts restatement

A fix on the extent of the scam was reached only after the accounts were redrawn. Tech Mahindra, which took over Satyam Computers in April 2009 for around ₹2,900 crore and renamed it Mahindra Satyam, presented the restated accounts in September 2010. As per these, the financial fraud was to the tune of ₹7,855 crore. This comprised around ₹6,243 crore till April 2008 and ₹1,612 crore since then. This was close to what Ramalinga Raju had indicated in January 2009.

The account restatement resulted in exceptional items which contributed to a massive loss of ₹8,177 crore in FY 2009 and a loss of ₹125 crore in FY 2010.

Ricoh India: Inflated numbers

Within years of the emergence of the Satyam scam that resulted in improved regulations in corporate reporting, disclosures and governance, a similar fraud from Ricoh India — an Indian arm of the Japanese multinational, Ricoh Global — came to light.

Ricoh India, too, escalated its revenue and pushed up profits and reserves by fudging accounting entries that were not supported by actual transactions, as per the forensic audit report of PwC. SEBI also pointed out large-scale irregularities in the company’s business transactions and manipulations in the books of accounts, amounting to fraud.

Eventually, the investors of Ricoh India were left in the lurch as trading was suspended and moved to Z category of the BSE — where settlement takes place on a trade-for-trade basis.

Later, the company, suo moto, filed for insolvency as it was unable to meet its liabilities.

What happened

The company did not get much investor attention till 2012-13, when it forayed from the business of retailing digital printers and the imaging equipment to cloud computing and other IT services.

Ricoh’s revenue grew multi-fold from ₹633 crore in FY13 to ₹1,638 crore by FY15, with losses (₹1.3 crore) turning into profits of ₹33.9 crore. This triggered a manic rally in the stock, which rose vertically from sub-₹100 in November 2013 to over ₹1,000 by June 2015. This resulted in the valuation soaring, aided by impressive order-books. Increase in debt was construed as a sign of growing business.

But what led to the sharp rise in revenue and profits, as per PwC report, was the booking of revenue before completion of the projects, and ‘channel stuffing’ — the company shipping more goods to the distributors and the retailers without commensurate demand from the end-users. Reports also stated that the company delivered products or services to non-existent customers.

Back-dated entries without supporting transactions also led to increase in the company’s profits and reserves. For instance, a single adjustment to the books of accounts of ₹67 crore (net) in the quarter-ended June 30, 2015 resulted in a loss of ₹64 crore being converted into a profit of ₹2.7 crore.

Suspicion about the company’s financial health arose when it delayed releasing results for the quarter-ended December 2015.

Subsequently, Ricoh, in April 2016, on the basis of the above-mentioned preliminary forensic audit findings, informed SEBI about the irregularities in the books of accounts.

A loss of ₹1,118 crore was disclosed for FY16 (against profit of ₹33 crore in FY15) due to reversal and write-off of provisions and unsupported book entries.

Accusations that the auditors, who gave true and fair view of the financial statements in the previous years, were privy to such irregularities cannot be ruled out.

Sun Pharma: Inadequate disclosure

At the outset, it must be said that this is not a case of accounting fraud. Sun Pharmaceuticals in 2017 sought approval from its shareholders to enter into related party transaction with Aditya Medisales (AML). The latter was controlled by the promoters of Sun Pharma. However, AML was dealing as a third-party distributor of Sun Pharma’s domestic drugs and formulations business for a long time.

How did Aditya Medisales remain hidden as a related party for so long then?

Multiple investment companies owned by the promoters of Sun Pharma controlled AML. However, the direct holding of the companies classified as Sun Pharma’s promoters was below the threshold that would have led to AML being classified as a related party.

When the company declared AML as a related party in 2017, the shareholders approved it in the annual general meeting. Sun Pharma declared AML as a related party in 2017 after the promoter group consolidated its holdings in AML, thereby crossing the threshold for being classified as a related party.

Sun Pharma conducted a conference call with investors to make it clear that the transactions with AML were at an arm’s length basis and that there were no wrongdoing in these dealings.

Whistleblower complaint

All of this came out in the open when a whistleblower complained to market regulator SEBI of funds being siphoned out of Sun Pharma by promoters from AML and another promoter-controlled entity Suraksha Realty.

SEBI had sent queries to Sun Pharma to understand the modus operandi of the operation of the third-party distributor. The progress on this action by SEBI is unclear. Sun Pharma said it had responded to the market regulator’s query about the whistleblower’s complaint.

Sun Pharma, on its part, moved swiftly to calm investors’ nerves. Dilip Shanghvi, promoter and managing director of Sun Pharma, said that shareholders weren’t at a disadvantage in the arrangement with AML. Bowing to shareholders’ anguish and pressure, Sun Pharma took over the distribution operations from AML and started distributing domestic drugs and formulations on its own.

It therefore pays to keep an eye on the various related-party transactions. Even if they are above board legally, investors must note that not all companies can be as swift as Sun Pharma to annul arrangements with related parties.

Enron Corp: Falsifying accounts — a wake-up call for regulators globally

The accounting fraud in Enron Corp towards the turn of this century, perhaps had the most widespread ramification with respect to the manner in which financial statements were reported, corporate governance practices as well as regulations.

Enron’s story is one of spectacular growth in the 1990s, as the natural gas pipeline operator decided to branch out into other areas such as natural gas trading and telecommunication and other geographies.

Lauded as the most innovative company in America by Fortune magazine for six consecutive years from 1995 to 2000, most Wall Street analysts were betting heavily on the Enron story in the 90s. But Enron’s diversification proved to be its undoing.

Its telecom venture — wherein, it invested large sums in online marketers and service providers, constructed a fibre optic communications network, and attempted to create a market for trading broadband communications capacity — was initiated towards the peak of the dotcom bubble, resulting in heavy debt on its books. When the bubble burst, these ventures turned non-profitable, while the debt remained on the books.

Enron’s investments in public utilities in India, South America, and the UK ran into trouble due to opposition from local political parties. Three, its energy trading business, while appearing to be making money, was actually boosted by creative accounting.

Accounting fraud

Despite many of its new ventures turning non-profitable, the company continued to present strong growth numbers by falsifying its accounts. This was done in numerous ways.

One, through the use of ‘mark-to-market’ accounting, for which the company received the SEC’s nod in 1992. This allowed the company to show estimated profits in many ventures against actual profits.

In July 2000, Enron entered into partnership with Blockbuster video rental chain.

This was a high-growth segment and Enron began recording expected earnings based on future growth, inflating its revenue greatly.

The high-speed broadband telecom network, in which millions of dollars were spent, also became non-profitable as the dotcom bubble burst.

The use of ‘special purpose entities’ to hide business losses and almost worthless assets was perfected by Enron. It is reported that Enron would build an asset such as a power plant and, immediately, recognise the projected profit on its books, even if the plant was not operational.

If the revenue from the plant fell short of projections, instead of taking the loss, the company would move the asset to SPEs, where the loss would be concealed.

Enron also disguised bank loans as energy derivative trades to conceal the extent of its indebtedness. Once all these creative accounting methods were revealed, Enron’s profits vanished and the stock price collapsed.

Shareholders, including thousands of Enron workers who held company stock in their 401(k) retirement accounts, lost billions of dollars.

The outcome

The main outcome of the Enron scandal was the enactment of the Sarbanes-Oxley Act of 2002, which brought about changes to securities law in the US and led to other countries adopting them. Auditors came under greater scrutiny in the US with the SOX Act creating a Public Company Accounting Oversight Board, operating under the SEC, to regulate independent auditors of publicly-traded companies. It prohibited auditors from providing certain consulting services to their audit clients and made pre-approval by the company’s board for other non-audit services necessary.

Published on August 18, 2019
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