Recent frauds like IndusInd’s derivatives fraud and Gensol’s diversion of fund are stark reminder that it is difficult to make a fraud free financial reporting system even if best of the efforts are put in by regulatory system to create such a system. These frauds have caught both the industry and investors off-guard as most of them believed that after enactment of Companies Act 2013 and creation of National Financial Reporting Authority(NFRA), it is very difficult to execute the frauds like diversion of funds especially which happened in gensol’s case. The IndusInd fraud is a more sophisticated fraud that used the accounting discretion.

Companies Act (2013) is a very comprehensive law ,that was enacted in aftermath of Satyam scam, to ensure proper reporting system as well as fix accountability of auditors and independent directors who used to conveniently ignore management’s whims and fancies for their own benefit. The law made sure that companies appoint independent directors and auditors, who are truly independent and act as trustees of investors and other stakeholders sans management. Though it has definitely increased the level of corporate governance but yet it is evident that management still yields a great control over auditors and independent directors by way of information asymmetry and by controlling their compensation benefits.

Gensol Fraud is a classic case where auditors and accountants knew that funds were getting diverted but yet they chose to remain silent even when it is their main job to red-flag such diversion of funds. Accountants should not have allowed it and Auditors should not have overlooked it. But both conveniently let it pass through and it is a case of through investigation and both of them should be fixed for not performing their roles properly. Of course, if they would have performed their role , they would have got fired from the company but they could have saved integrity of capital markets. But IndusInd bank fraud looks to be far more sophisticated that relates to use of accounting discretion rather than straight away diversion of funds.

IndusInd Bank used the accounting discretion available in classifying financial securities.Financial securities can be classified into three types:Available for Sale,Held till maturity and Held for trading.The movement of financial security from one category to another can significantly impact the net income that a bank reports .For example, a security classified as held for maturity will not record notional profits/losses in its income statement whereas same security if classified as held for trading can record profit/losses immediately in income statement.So , if one wants to boost net income then one can simply record notional profit on books by reclassifying the securities.In the same way, losses can also be postponed.

While it is crystal clear that both the frauds were preventable only if auditors were more vigilant in investigating the actions of management in timely fashion, it is also true that Gensol fraud was a plain vanilla fraud that should have been absolutely avoidable given stringent regulations governing diversion of funds but yet, it happened is a very strange thing.On the other hand, IndusInd bank tried to use accounting discretion to boost profits to keep investor interest intact.What they did was not very easily detectable since management has discretion to do such re-classification but the fact that such re-classification was done with an attempt to mislead investors is breachful of trust investors had in the management.

Thus, one can say that while frauds like gensol are clearly preventable in the current regulatory scenario but frauds like IndusInd one’s are not easy to catch given that they use the leverage given in the accounting standards to window dress income statement where auditors can question but cannot clear-cut conclude that it is a fraud since management strategy can desire such changes.Of course, brokerages should have seen it through but pre-occupation of brokerages with price per earnings and price targets generally ignore painstaking effort required in doing such an enquiry.Thus, preventing such a fraud depends mainly on expertise of auditors and vigilantism of investors and is unlikely to get regulated since accounting will continue to have discretion and till there is discretion, the chances of fraud will continue to be there.

Noted:Both the frauds are under investigation. The conclusion inferred in above article is only based on information available in public domain