NFRA’s R Sridharan: Loose drafting of law and muddle-headed thinking have led to regulatory capture
As we learnt from our recent trip to New Delhi, there is a massive punch-up playing out at present for control of the audit & accounting profession. In the blue corner is the ICAI, the chartered accountants’ trade body, which is protecting its turf and its members. In the red corner is the National Financial Reporting Authority (NFRA) which was created three years ago to regulate audit & accounting professionals. A lot is at stake here because at Marcellus we see on a daily basis that corrupt auditors are responsible for one of the central faultlines in India’s financial system. As explained in Chapters 2 & 3 of our latest bestseller “Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation”, nearly one in two listed companies in India publish financial statements with serious accounting irregularities. As is evidenced by the detailed case studies of accounting fraud we have provided in the book, an auditor with half a brain would be capable of figuring out that the numbers he’s signing-off on are cooked. And year after year, for company after company this fudging continues. The result is that seventy years after independence, India’s bond market is still comatose for all but a handful of blue chip companies, banks refuse to extend credit to companies for capex and the Indian stockmarket is the least liquid of the world’s top ten stockmarkets.
So who will reform the audit & accounting profession? Who will be India’s Arthur Levitt, the famous SEC boss, who in the 1990s laid bare the corruption in the published audits of leading American companies? Enter the boss of the NFRA, R Sridharan. In this hard hitting interview with the ET, he makes three critical points:
- The ICAI has failed to regulate the profession properly: “Section 132 (Companies Act, 2013) is our Gangotri. Law has to be interpreted after first understanding the mischief it is designed to cure. The mischief here is the utter failure of self-regulation of the audit profession. Self-regulation of the audit profession has been shown to be a failure all over the world. There is just no exception and there is no jurisdiction where self-regulation is accepted. So, one of the basic points of the ICAI was that ‘as far as we’re concerned, we are doing a great job, self-regulation in our case is okay. There’s no reason we should be subject to an independent external audit.” But that is a statement which has to be taken with a pinch of salt.
So, this is the basic situation. Why is Section 132 there? Why is this body created? This is created because you need an independent and external audit regulator. Why is that important? Because self-regulation has been shown to have been a failure…it has failed all over the world, everywhere. No amount of whitewashing of this by the ICAI will be convincing.”
- Bad drafting of Section 132 of the Companies Act: “Section 132(3), prescribing one chairperson and up to 15 members, with one full-time and part-time members to be decided by the government is an example of both” bad law and of muddle-headed thinking…
ICAI took full advantage of the loose drafting of Section 132(3) to drive a coach and four through. Three office bearers of the ICAI were included in the rules as part-time members, and an additional provision was retained for two more expert members, possessing universal qualifications. The stage was set for attempted regulatory capture of the NFRA by ICAI. This was absolutely lethal to the attainment of the key objective of the Section viz., the substitution of self-regulation by independent regulation.”
- The nature of accounting is changing for companies with valuable intangible assets: “Many of the issues are captured in a book called ‘The End of Accounting’ by Baruch Lev and Feng Gu. So what really is happening is accounting is not really in a position to provide too much information about these companies. Because their strength lies in their intellectual property, in their patents, in the creativity of the people they assemble. None of these things enter into the numbers. So, by looking at the accounts, you won’t get an idea. So, for all these people who invest money in them, the two professors said, not more than 4-5% of the total information comes from the accounting data.”