An Instance of Accounting Fraud

The New York Times analyzes an instance of possible accounting fraud at a Chinese company, Longtop Financial Technologies that has close similarities with India’s own Satyam scandal (i.e. improper confirmation of bank balances). While the Satyam scandal came into the public domain through a confession letter of the Chairman, in this case the auditor blew the whistle. Here is an extract:

Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31. But for some reason — Deloitte did not say why —the auditor went back to Longtop’s banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop’s cash really was on deposit. And that set off panic at the software firm.

 
It is reported that SEC has begun an investigation, which will also throw the spotlight generally on non-US companies listed on US stock exchanges.

MCA grants exemption from attaching subsidiary accounts

Section 212 of the Companies Act, 1956 requires holding companies to attach with its balance sheet, a copy of the balance sheet, profit and loss account etc., of each of its subsidiaries. In recent years, with the globalization of the Indian economy, there has been a large increase in the number of holding companies and subsidiaries. Accounting policies and practices have also evolved, and Accounting Standards have been issued regarding preparation of consolidated financial statements.

The Ministry of Corporate Affairs has been receiving a large number of applications seeking exemption from attaching the accounts of subsidiaries. The Ministry has been granting such permission in certain cases on the basis of certain conditions which are intended to protect the interests of investors. The Ministry has carefully re-examined the matter in the context of the emerging trends in the economy and regulatory and accounting practices and has decided that the permission may be granted on a general basis wherever the Board of Directors of the holding company gives its consent and the conditions prescribed are complied with. Accordingly, the Ministry has issued directions through General Circular No. 2/2011 for this purpose.
The conditions to be met by the companies to avail the exemption are set out below:-

(i) The Board of directors of the company has by resolution given consent for not attaching the balance sheet of the subsidiary concerned;

(ii) The company shall present in the annual report, the consolidated financial statements of holding company and all subsidiaries duly audited by its statutory auditors;

(iii) The consolidated financial statement shall be prepared in strict compliance with applicable Accounting Standards and, where applicable, Listing Agreement as prescribed by the Security and Exchange Board of India;

(iv) The company shall disclose in the consolidated balance sheet, the following information in aggregate, for each subsidiary including subsidiaries of subsidiaries: (a) capital (b) reserves (c) total assets (d) total liabilities (e) details of investment (except in case of investment in the subsidiaries) (f) turnover (g) profit before taxation (h) provision for taxation (i) profit after taxation (j) proposed dividend;

(v) The holding company shall undertake in its annual report that annual accounts of the subsidiary companies and the related detailed information shall be made available to shareholders of the holding and subsidiary companies seeking such information at any point of time. The annual accounts of the subsidiary companies shall also be kept open for inspection by any shareholders in the head office of the holding company and of the subsidiary companies concerned and a note to the above effect will be included in the annual report of the holding company. The holding company shall furnish a hard copy of details of accounts of subsidiaries to any shareholder on demand;

(vi) The holding as well as subsidiary companies in question shall regularly file such data to the various regulatory and Government authorities as may be required by them;

(vii) The company shall give Indian rupee equivalent of the figures given in foreign currency appearing in the accounts of the subsidiary companies along with exchange rate as on closing day of the financial year.

(Many thanks to my esteemed colleague, Sabyasachi Chatterjee, for spotting this development!)

Financial Disclosures by Companies

A column by Rahul Roy in The Business Standard deals with the proposed revision and simplification of Schedule VI to the Companies Act. This schedule prescribes the presentation and disclosure requirements for financial statements. The column strenuously argues that the current version of Schedule VI is severely outdated and as to how it should be brought in tune with developments in the financial world. However, questions are raised about whether amendment to Schedule VI is the right way to proceed:

“Globally, professional bodies of accounting standard setters prescribe accounting formats. The advantages are obvious. This is a specialised area which requires professional input; and has to be updated frequently to keep pace with changes in the economic and commercial environment. A schedule to a law, which has to be debated and amended only by Parliament obviously does not offer the flexibility required. Also given the scheme of things, an accounting legislation may not be the highest priority of our Parliamentarians.

Today, the prescriptions of Schedule-VI are far removed from the reality of what financial statements mean. It is only a legal figment that accounts in India comply with Schedule-VI. For starters, Schedule-VI does not even have any prescribed format for a Profit & Loss Account; it does not require a cash flow statement; it does not require disclosure of accounting policies; it does not require disclosure for leases; it does not warrant disclosure of deferred taxes or disclosure regarding impairment losses or intangibles. Further, the Schedule VI was conceived in an era when nobody had even heard of derivatives and so remains blissfully unaware of derivatives and disclosure of potential losses therein.

On the other hand, the Schedule-VI requires detailed disclosure of inventories, capacity, production and turnover for every significant item produced or traded. This is not required under any global framework and is potentially disadvantageous for the Indian industry vis-à-vis its global competitors as it forces companies operating in India to disclose their confidential operating data. These disclosures were conceived in a "Licence Raj" era and serve no useful purpose today when alternate Segment Reporting data is already available.”

In addition, the Rahul Roy points to the multiplicity of prescriptions that operates in relation to disclosure of financial statements, and the compounding confusion that it brings about:

“While on one hand the MCA is trying to reinvent the Schedule-VI, on the other hand multiplicity and confusion in the standard setting process in the country is increasing. ICAI's Accounting Standards Board is setting Standards; the National Advisory Committee of Accounting Standards (NACAS) is considering and notifying Standards; the MCA is notifying Rules (Accounting Standards Rules, 2000) that directly contradict Schedule-VI thereby creating a legislative conflict by specifying that a Rule will override an Act !!; the RBI is issuing provisioning & income recognition guidelines; SEBI is mandating presentation and disclosure formats of interim and annual results; and the ICAI is busy issuing ‘announcements', impacting accounting but without either the due diligent process of formulating Standards or investing these announcements with the authority of a mandatory pronouncement.”

Accounting for Derivatives Exposure

A recent announcement by the Institute of Chartered Accounts of India (ICAI) has added to the imbroglio over derivatives. Accounting Standard 30 (AS30) that deals with accounting for derivatives was to become mandatory with effect from April 1, 2011. However, the ICAI in an emergent decision has called for an early adoption of AS30 for financial statements as on March 31, 2008. Corporates not following AS30 are required to measure unrealised losses on financial instruments using principles of prudence explained in AS1. The Business Line has a report on the implications.

This appears to be a knee-jerk reaction to recent events and is likely to cause a stir among corporates in their year-end reporting. Business Standard has an editorial today that touches upon some of the issues:

“… The problem of course is that the directive has come on a week-end, with one working day left for the financial year to close for most companies. Saddling companies with a serious accounting change at the very end of the year has given them an unpleasant shock, and many of them will be scrambling to deal with this last-minute situation. This is not the way in which matters should be dealt with.

The new accounting directive should mean that all the facts will be known when the March accounts are reported, but shareholders may remain in the dark about the true dimensions of the potential problem. If some companies are tempted to take the view that many foreign exchange derivative contracts have maturity dates that are still in the future, and therefore they can legitimately take the view that until the stipulated date comes round, there are no losses to report. Since some of the affected companies have gone to court against the banks that sold them the derivative contracts, they will be taking legal advice on whether they have a strong case, and whether that gives them protection from “marking-to-market”.

Companies will be eager to look for such escape routes as the immediate disclosure of large exposures could endanger their relationships with other bankers and suppliers, with the attendant risk of credit drying up and affecting the running of the business. However, the accounting norms that have been introduced do not leave any room for such creative thinking. There is also the possibility that banks and companies will work out arrangements whereby existing derivative contracts are unwound, and replaced by new contracts that have an even longer maturity period. But even this will not prevent full disclosure to shareholders. In any case, such “ever-greening” of loans also runs the risk of increased exposure, and a bigger problem being bought for the future.”