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Dear Mr Jaitley, this is why auditors of PNB failed, and you can help prevent this in future

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Finance Minister Arun Jaitley yesterday broke his silence on the PNB scam. Among others, he laid the blame on the auditors of PNB, for not having detected the fraud. A lay person may be justified in holding the above view. But Mr Jaitley, being the finance minister should know the background and context. As a Chartered Accountant who has been part of several bank audit assignments in the PSU banking space, I would like to elaborate on the situation we deal with it.

Role of an Auditor

The primary objective of an auditor is to critically is to express his opinion regarding ‘true and fair view’ of the financial statements and in doing so he should take all necessary steps to prevent and detect frauds and errors. But obviously, there is a possibility that a fraud may get detected later. Would that mean that the auditor did not do his/her duty responsibly? The answer to this question was given in a landmark judgement, from the year 1896 i.e. the Kingston Cotton Mills Co. Ltd. Case. It was held that:

An auditor is a watchdog not a bloodhound

The import of the above is that the auditor must act in neutral manner, applying reasonable skill and care, but is not expected to have a suspicious mind. The role of a “bloodhound” is investigative in nature, and needs deep, critical research into the material, which an auditor is not generally expected to do. Refer to any audit report, including that of PNB, for the year in question, and you will find a standard line in the auditor’s report:

An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.

Audit reports themselves always highlight the limitations of the exercise and declare very clearly that the audit is performed on a “test-check” basis where random samples of transactions are selected and audited. Given all of the above, an auditor can be held guilty for not detecting a fraud, only if it can be demonstrated that he has not exercised the basic checks he is expected to use.

Practical challenges in Bank Audit of a PSU Bank

A PSU bank branch of substantial size, will typically have a concurrent auditor and a year-end external auditor.

A concurrent audit is a year round exercise where-in an auditor is expected to audit the dealings of the branch, through-out the year on a monthly basis. In theory, these people are the best suited to detect such issues, but due to archaic audit report formats and practices, they end up checking more routine transactions and are seldom in a position to add value. Moreover, these auditors are appointed by the bank itself, so there is always the fear that if such an auditors plays tough, he maybe replaced.

The position of the external year-end auditor is even more precarious. Typically, a PSU bank will itself appoint the external auditor for its branches. The choice is completely left to the bank, out of a pool of auditors who have been deemed to be qualified enough. The conflict of interest is apparent: a bank chooses who will question it.

These auditors are usually appointed in the last week of March and are expected to audit 2 to 3 branches within 2-3 weeks (on a higher side). Within this restricted time, auditors are expected to assemble a team, travel to the branches allotted, which can often be in other states, complete the audit and sign off on hundreds of papers. The audit reports of each branch are further sent to higher ups which are then collated and given to the Central Auditors, who prepare the consolidated report for the bank on an all-India basis. Auditors are told that all this has to finish by April end since they have to publish the final accounts soon.

The question is: Why this tearing hurry? Why do PSU banks have such a hurry to get their branches audited and publish the accounts? Why not allow a comfortable time-schedule to get a thorough audit done. Why are auditors appointed almost at the end of the year? Why not appoint them in advance and let them get even more time to check the bank’s accounts in a comfortable time frame?

At this point it is important to mention that due to the above short time-frame, such audits have become lucrative for CAs as well. For work of 2-3 weeks, the CAs are remunerated substantially well. PSU banks have in fact cribbed about this often, that their cost of audits is too high, and have asked to reduce the number of branches needed to be audited. Instead of asking the auditors to provide more value, by increasing their scope and period of audit, banks have been batting for doing away with audits in this fashion.

Next, the structure of these audits is also peculiar. A CA has to audit a branch, and both he and the branch manager have to sign off on the reports. If an auditor is expected to audit a branch i.e audit the performance of the branch manager, should he report to the same manager, or should he directly contact the higher ups? In every bank audit, the auditor’s report is seen by the bank manager himself, and it is a common sight to see the manager plead with the auditor to drop various observations which may put the manager at risk. Many auditors succumb to this pressure. One of the reasons could be that since the bank controls their appointment, and since the assignment is lucrative, the auditor may fear being dropped for being “uncooperative”.

The reports asked from auditors are also an issue. Many of the reports and documents asked to be signed off by auditors are old, out-dated and have no relevance in a computerised, core banking system, which all PSU banks use. The volume of these reports is also substantial. It is not uncommon to note that many of these reports are not ready with the branch itself, until the 2nd week of April. This brings us to the same issue again of insufficient time. With pressure from the bank officers, unrealistic deadlines, and huge volumes of documents, auditors often find themselves signing thick bundles which they can barely read, let alone comprehend.

Time for an overhaul

The PSU bank Audit system in our country is certainly broken. A bank is allowed to choose the auditors it pleases, gives them a very small window of operation, makes them sign on huge sets of irrelevant data, and fails to extract actual quality work. Auditors are made to report to the very managers who they are auditing, and are under constant threat of losing a lucrative assignment.

The system is broken, but can be mended:

A. All audit appointments must be made by a third party, like the RBI. PSU banks should not be allowed to choose their auditors

B. Auditors should be given sufficient time to do their duties

C. Auditors should directly be asked to report to the higher ups at the Zonal offices etc

D. Audit Reports need to be upgraded to ensure clerical work is minimised and value addition is maximised.

If after all of the above, an auditor is found to be negligent, then surely action should be taken on him. Till then, do realise that we are all working with the best possible tools and opportunities available to us.

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