PNB scam and banking sector crisis: Will NFRA reduce fraud risk?

Fraud in business firms, particularly in financial institutions, is not uncommon. The Reserve Bank of India (RBI) data, which Reuters obtained through a Right To Information request, show that the public sector banks (PSBs) have reported 8,670 “loan fraud” cases, totalling Rs 612.6 billion, over the past five financial years up to 31 March 2017. RBI had flagged bank fraud as an “emerging risk” in its Financial Stability report published in June 2017. The PNB fraud has caught the attention of media because of its size Rs 127 billion) and the long period (seven years, since 2010) over which it was carried out without detection in spite of audits and RBI inspection. PNB fraud occurred due to inadequate and ineffective internal control. Investigation at different levels will reveal why the fraud could not be detected early and who all were involved in the criminal conspiracy. 

Many commentators quickly concluded that inability to detect PNB fraud is an audit failure. Perhaps many others share that view. As reported in the Telegraph (Calcutta edition dated March 4, 2018), the Association of Chartered Accountants (Kolkata), which is not an arm of the Institute of Chartered Accountants of India (ICAI), but whose members are members of ICAI, holds the view that the auditors might have compromised independence, because they were selected by the management of the bank. Since 2014-15 management selects the auditors. Earlier RBI used to select auditors from a list prepared by ICAI. The Association demands that the government should revert back to the old procedure of RBI selecting auditors of PSBs. The view of the Association reflects the widespread concern that auditors, who are de facto appointed by the management, although, de jure they are appointed by the shareholders, find it extremely difficult to protect independence under the subtle pressure of the management. 

Audit quality is a matter of concern for regulators. Across the globe, regulators are experimenting with varieties of audit reforms. Rotation of auditor (or audit partner), prohibiting the auditor from providing other services and external monitoring by an independent regulator are the three important reforms introduced in many countries in recent years. The government had decided to introduce those reforms to improve the perceived audit quality by incorporating appropriate provisions in the Companies Act 2013. None of those three reforms is Indian innovation. 

The government's decision to set up the National Financial Reporting Authority (NFRA) is a decision to implement one of the audit reforms introduced in the Companies Act 2013. Every audit reform has pros and cons. Therefore, it is appropriate to debate a proposal extensively before deciding the need and form of implementation.  For example, in the US, the rule, that requires public identification of the engagement partner, has been introduced after long debate, although similar rules, which aim to enhance the accountability of engagement partners, is in place in India, the UK and many other countries for long. Public Company Accounting Oversight Board (PCAOB) floated the idea in 2009, the rule was approved in 2016 and has come into force from January 31, 2017. We should not read too much into the delay in deciding setting up of the NFRA.    

The decision to set up the NFRA and detection of PNB fraud coincided. It has led many commentators to link the two, giving the impression that external monitoring by the NFRA would significantly reduce the incidence and magnitude of frauds. This is nothing but fantasy. The NFRA will strengthen external monitoring of audit quality in listed companies, large public interest companies and other companies to be referred to it by the government. It will investigate reported audit failures and penalise errant auditors and audit firms. Effective external monitoring is expected to improve the audit quality due to better compliance with auditing standards. However, it is unlikely to mitigate fraud risks significantly, because audit procedures are not designed to detect fraud, for which forensic audit is required, and species of rogue auditors, who transgress ethical boundaries, will not extinct. In Satyam, the auditors colluded with main protagonists in committing fraud. The initial investigation into the PNB fraud hints the same. 

Setting up of the NFRA should not be viewed as an indictment of ICAI. It is just catching up with the global trend in audit reforms. Media should restrain from berating the CA profession. It will reduce the public trust in the audit. This is dangerous, as investor confidence in financial reports is fundamental to the successful operation of the financial markets, which is necessary to ensure the flow of investible funds to productive assets and economic growth. 

The author is group mentor, Institute of Management Technology Ghaziabad
Twitter @AsishB50

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