A study called 'Early Warning Signals of Corporate Frauds', conducted by the Pune-based Indiaforensic Consultancy Services, a forensic accounting and education firm, from January 2008 to August 2008 has come out with shocking revelations about corporate frauds.

Study details

The study has revealed that at least 1,200 companies out of 4,867 companies listed on the Bombay Stock Exchange and 1,288 companies listed on the National Stock Exchange as on March 31, 2007, including 25-30 companies in the benchmark Sensex and Nifty indices, have massaged their financial statements.

The study investigated 11 sectors, viz. real estate, retail, banking, manufacturing, insurance, public sector undertakings, mutual funds, transport and warehousing, media and communications, oil and gas and information technology.

The manufacturing sector, which contributes about 28 per cent of India's gross domestic product, is the one most ridden with fraud mainly due to the peculiar nature of the business and the procedural complexities inherent in this sector. Real estate and public sector undertakings came second.

The motive for committing accounting statement frauds, according to 73 per cent of 340 chartered accountants who were respondents to the findings of the study, was to exceed expectations of stock market analysts. Other reasons for the fraud include credit-hungry firms manipulating application data in order to qualify for credit.

The KPMG India Fraud Survey Report 2008 showed that more than 80 per cent of respondents recognise fraud is a problem and 70 per cent believe it will increase over the next two years.

Accounting fraud is the worst type of fraud, shattering as it does the very basis of investor confidence in financial statements. In fact, investors eagerly await corporate results quarter after quarter, and if these statements themselves are manipulated, the efficient market theory relating to price formation itself does not hold good. As such, frauds cannot continue to be committed for long, prices will ultimately find their own realistic levels.

The beneficiaries of the frauds are those responsible for the fraud, including the personnel in the accounts departments of companies, auditors and concerned directors of companies and others who are in the know of things, all at the cost of the ordinary investors. It is possible that the fraudsters and those in the know of fraud may be indulging in insider trading, committing yet another serious offence.

Clause 49

It is indeed sensational that accounting frauds of such a large number of listed companies have occurred, despite the fact that Clause 49 of the Listing Agreement has been in operation for the last few years.

Clause 49 of the Listing Agreement provides, inter alia, for the Board of Directors to have at least half the Board to be independent directors, and for a qualified and independent audit committee with two-thirds of the members being independent directors and the chairman of the committee also being an independent director.

The audit committee should have an oversight of the company's financial reporting process and disclosure of its financial information "to ensure that the financial statement is correct, sufficient and credible."

Besides, the chief executive officer, as also the chief financial officer of the company have to certify that the financial statements do not "contain any materially untrue statements or omit any material fact or contain statements that might be misleading", "present a true and fair view of the company's affairs" and that no transactions of the company "are fraudulent, illegal or violative of the company's code of conduct."

Over and above these are internal auditors, apart from and the statutory auditors who have to certify that "no material fraud on or by the company has been noted or reported during the year."

With all of the above mentioned in-built checks and balances and the Department of Corporate Affairs of the Government of India overseeing the working of companies all over the country, it is amazing that about 20 per cent of the listed companies have successfully managed to come out with financial statements that are fraudulent.

Corrective action

What is needed is immediate corrective action. The Department of Company Affairs /Securities and Exchange Board of India (SEBI) should order immediate special audits of the relevant years of these companies where frauds have occurred.

Suitable penal action should then be initiated against the directors of  the company and all others involved in cases where special audits reveal frauds.

The Institute of Chartered Accountants on India should also take suitable penal action against the concerned chartered accountants. The role of independent directors need also to be ascertained; is it just negligible or  connivance, neither of which is pardonable.

Not just that. In all cases where the fraud is of a serious nature, which if revealed in time would have had a significant influence on the movement of stock prices, Sebi should start investigations of transactions in the shares of these companies to detect cases of insider trading. Needless to say that penal action must follow all cases where insider trading is detected.

Besides all these, the proposal of the Ministry of Finance to make it mandatory for companies to publish their balance sheets every quarter (which is presently done once a year), along with the profit and loss account, which will help the investors to know the liquidity and solvency of the companies, needs to be implemented urgently. This will, incidentally, bring India closer to international disclosure standards.

Guidance

If the actual financial statements are incorrect, chances of knowingly manipulating the figures relating to subsequent quarters for guidance of investors are greater still, particularly in the context of the desire of most of managements to show better results in the short-term, which may not always be in the long-term interest of the company.

Former chairman of SEBI, M Damodaran, had called for a public debate on this issue.  Although a joint call to end quarterly EPS guidance was made recently by the CFA Centre for Market Integrity and by the Business Roundtable Institute for Corporate Ethics, the matter has not been pursued. It is time that the issue is revisited in the context of the revelations made by ICS.

Conclusion

Any relaxation towards the guilty will encourage the fraudsters to continue their fraudulent activities, affecting adversely not just the process of price formation on stock exchanges, but also the very basis of the functioning of the corporate world.

It is relevant to note that several of the leading companies in the United States, including Enron Corporation, Imclone Systems, Tyco International as also the leading accounting firm, Arthur Anderson, who were all involved in huge corporate frauds in the 2002 financial scam are serving time in jail.

Recently, Bernard Ebbers, CEO of WorldCom, who was involved in an $11 billion accounting fraud, was sentenced to 25 years of imprisonment, despite his heart condition and he being called "an angel to desperate charity causes."

Indian authorities do need to take a lesson from the United States. Will they?

The author is a former Executive Director, Bombay Stock Exchange.