NSEL: Audit Failure?

Published on Sat, Nov 09,2013 | 17:32, Updated at Sat, Nov 09 at 17:32Source : CNBC-TV18 | Watch Video :

We've examined the 5600 crore rupee NSEL scam in different ways on the show - what went wrong, why the FMC could do nothing about it and whether savvy brokers and investors failed in doing adequate due diligence. But our coverage would be incomplete if we didn't ask - why the statutory auditor did not see the writing on the wall? Especially since the forensic audit points to violations such as inadequate margins, margin limit exemptions and violations and mis-utilisation of settlement guarantee funds for the Exchange's private use. This week, Payaswini Upadhyay asks experts if NSEL's statutory auditors in the previous year did what they should have?

The Forward Markets Commission came up with a 5,000 crore rupee question - is Financial Technologies or FTIL, the parent of NSEL, fit and proper to run an Exchange?

This question was part of the FMC's show cause notice to FTIL on the 4th of October. It was accompanied by some telling observations made by Grant Thornton in its forensic audit of the exchange!

Between 2009-2013, NSEL granted more than 1,800 margin limit exemptions...

NSEL violated its own bye-laws by allowing members to increase exposure without sufficient collateral. Case in point: Lotus Refineries defaulted on 198 days between April 2012 and July 2013.

In March 2013, NSEL withdrew 236 crore rupees from its Settlement Fund to finance its own business overdraft account.

NSEL provided credit facilities to buyers by way of corporate guarantees.

While NSEL claimed to have 2,389 crore rupees worth of stock in 16 warehouses, it actually has stock worth just 358 crore rupees.

Now NSEL's auditor Mukesh Shah's audit report made no mention of these violations. It even vouched for the adequacy of physical inventory checks by the management, said there were adequate internal controls and said that NSEL did not provide a guarantee for loans taken by others.

In September last week, Mukesh Shah withdrew his audit report for the financial year 2012-13 saying it cannot be relied upon anymore. We don't know the reasons cited for this withdrawal but what we do know is that this 5,600 crore rupee scam at NSEL is not the doing of just one year. Experts say that if these violations that find a mention in FMC's show cause notice had been flagged off by the statutory auditor in the previous years, the damage could've been a lot less.

For instance, FMC's show cause notice takes note that in his internal audit report for April - September 2011, Mukesh Shah observed that NSEL was carrying out NBFC-like activities. These include funding transactions without an NBFC license. The notice also points out that NSEL engaged in a financing business where a fixed rate of return was guaranteed on paired contracts. The contribution of such contracts to NSEL's turnover (excluding e-series turnover) grew from 25% in 2010, to 97% in 2013. But this observation found no mention in the audit report prepared by SV Ghatalia & Associates, NSEL's statutory auditor in 2011-12.

JN Gupta
Founder, Stakeholders Empowerment
"If you see such a glaring violation, either you force the internal auditor to change his audit report which is not the cause as FMC notice has brought this out now or if you disagree with him, then write that internal auditor feels this way but we don't or you accept the internal auditor's report. So, in my opinion, it has been a blatant failure on part of Ghatalia & Co. not to report this and take it into account. In hindsight, I hope they are regretting had they done, this, it would've not reached this stage."

TP Ostwal
Managing Partner, TP Ostwal & Associates
"As a statutory auditor, it is my duty, no doubt to consider internal auditors reports & one important point which you have made out is that the internal auditor- if he points out that some of the activity which the company has carried out are not within the domain or object of the company- then it is definitely ultra vires activity; he has to report; he cannot ignore the reports and don't take cognizance of such reports. Therefore it becomes responsibility of the statutory auditor. However if the internal auditor points out so many issues which are not within the normal commercial parlance required to be reported & there is some extra caution, then the value judgment will have to be arrived at by the statutory auditor whether reports issued by the internal auditor is so material, that it will impact my thinking of giving a report which is true & fair and if it doesn't, then yes I must take cognizance of that."

FMC's show cause notice also points out that according to Grant Thornton, NSEL failed to implement adequate risk management to protect itself against the financial liability of its members. For instance, members were allowed to trade without sufficient collateral despite repeated defaults; margin limits were increased without adequate documentation on the credit history of the members and there was lack of data migration facilities even for critical operations.

Byte TP Ostwal
Managing Partner, TP Ostwal & Associates
"This has a direct impact on financials, for eg the data migration is not taking place is what the FMC has reported & there are different different softwares that were used for preparing some reports, which don't match with each other, then the auditors job is to manually do it, satisfy yourself if its matching properly or not & in that event if they see that matching is not taking place, then there is a genuine issue of reconciliation of accounts because of the different systems operating at the same time. Then the auditor must take cognizance of that event saying that this is a lack of internal control."

A closer look at NSEL's 2012 financial report indicates that more than 100% of its revenues were blocked in receivables. Proxy advisory firm SES points out that in the 2012 audit report, the figure that appears as advances recoverable was changed to expenses recoverable in 2013. Also, while income is shown as net expenses, these expenses are yet to be recovered.

NSEL: AUDIT FAILURE?
Financial Report

2011-2012: More than 100% of Revenue blocked in Receivables
     - Total Income (credit period applicable): Rs 74.50 cr
     - Receivables (Debtors: Rs 11.03cr + Advances Recoverable: Rs 144.03 cr): Rs 155.06 cr

2012-2013
Advances Recoverable from 2011-2012 mentioned as Expenses Recoverable: Rs 143.9 cr

JN Gupta
Founder, Stakeholders Empowerment
"In this balance sheet of 2011-2012, they have put a figure of advance recoverable of about Rs 144 crore. It is a nomenclature that explains that the company would have given advance for something. When you next year's balance sheet, you find that this is not advance given, it is expenses recoverable. Now when you're saying its expenses recoverable, it can't be advances, it has to go into sundry debtor. If you bring it to sundry debtor, it has two issues. One is that this transaction has not formed part of revenue - it is not under sale and purchase and it is recorded as net. This is a sundry debtor and if you take other sundry debtors, the total sundry debtors are more than the revenue declared. So there is something wrong; the auditors did not do their job properly."

Further, as per the financial report for FY12, around 354 crore rupees is shown as member liability. Against this, only 186 crores was available as cash or cash equivalents -- something, experts say, the statutory auditor should have flagged off.

NSEL: AUDIT FAILURE?
Financial Report

2011-2012
- Member Liability: Rs 354 cr
- Cash & Cash Equivalents: Rs 186 cr

TP Ostwal
Managing Partner, TP Ostwal & Associates
"The statutory auditor must take cognizance of the fact that how are you going to meet the liability of the members in case the liability is likely to be met? So to meet that liability whether 50% of the cash balance or cash equivalent in some other investment- if it is found, then it should be acceptable because if those amounts are realizable at any given point in time, for eg: bank balance is at X, plus there are other liquid assets, the auditor should be satisfied but here is a case where the bank balance is Rs 180 crores & liability is Rs 380 cr- Rs 200 cr gap has to be bridged. What has happened with the funds, has it been given as advance to somebody? And if this is not in the ordinary course of business, then auditor must take cognizance seriously."

SV Ghatalia and Associates sent us an email response saying "the audit of NSEL's financial statements as of and for each of the years ended March 31, 2010, March 31, 2011 and March 31, 2012 was conducted in accordance with the auditing standards generally accepted in India. We are bound by our confidentiality agreement with our client and are therefore unable to provide any further comments."

It is not our case that SV Ghatalia & Associates knowingly failed in their duty as statutory auditors. The issues highlighted and commented upon in this story seem like obvious red flags to us today… may be because we have the benefit of hindsight. But what this hindsight fails to explain is why even after this Pandora's box has been opened, SV Ghatalia & Associates has chosen to not withdraw its report.