A pedestrian walks past a Punjab National Bank (PNB) branch in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

PNB Should Provide For Entire Fraud Amount In Q4, Says Veteran Auditor

Punjab National Bank, which is at the centre of a near Rs 13,000 crore fraud involving jewelers Nirav Modi and Mehul Choksi, will have to account for the entire loss due to the fraud in the fourth quarter itself.

That’s the word coming in from S Santhanakrishnan, former central council member of the Institute of Chartered Accountants of India and managing partner at chartered accountancy firm, PKF. The fraud has to be provided for in the same financial year when it came to light, and in the fourth quarter in PNB’s case since the year is ending, he added.

The fraud amount will reflect in the profit & loss account and any loss will thereafter be adjusted against reserves, added Santhanakrishnan.

This comes after PNB announced to honour all 352 letters of understanding and foreign letters of credit worth Rs 6,500 crore maturing with seven banks on or before March 31. The state-owned lender’s profit is likely to take a massive hit for the quarter ended March 2018.

Watch the full conversation here:

Here are edited excerpts of the conversation:

How will PNB account for the fraud? So far it has said it will make good on Rs 6,500 crore worth of LOUs?

Under the present accounting standards as well as principles that all countries follow, the moment the loss is determined you provide for it. You don’t wait for the next quarter to come. If you know that the fraudulent action has taken place, then you take the whole loss and account for it in the same quarter. I don’t think there are any accounting principles which will allow you to defer this to next quarter. PNB will have look at all those LoUs, see what are bad and they will have to provide it today itself.

Given that currently it’s a contingent liability how would it be accounted for? Also there is an RBI circular that permits spreading the impact over four quarters?

It was a contingent liability as far as the transaction was not fraudulent. If it is fraudulent, then it is no longer a contingent liability but a crystalised liability. There is a distinction between a contingent liability and a liability which has arisen. When you have a LoU, it was a contingent liability. When you find a LoU is fraudulent, it is not longer a contingent liability. The regulatory forbearing or regulatory override does not override accounting. The regulator may say, in order to not create panic in the market, that you can provide (for fraudulent transactions) over the next four quarters. But in a fraud transaction, it is never done in four quarters.

Even the RBI circular must be looked at from a fraud angle and not as a circular which is generally applicable. For example, you provide for gratuity which is Rs 20 lakh now. The additional gratuity liability during the current year may be provided over four quarters because it is applicable throughout the year. But a loss which you have made currently is not applicable for the whole year. It has to be provided for in the quarter it was determined and not deferred, even according to the RBI circular. Removing it through reserves and not routing through the P&L account is more of a regulatory override and not an accounting override. Regulator has the right on how to account. But the accountants do not necessarily agree with the regulator’s view.

How will it be recorded in the PNB financials for the quarter?

It has to go through the P&L account. We will say provision for fraudulent transactions. It continues as the provision until finally it is determined. Instead of Rs 11,000 crore, it may become Rs 11,500 crore or Rs 10,000 crores depending on how much you will be able to realise from Nirav Modi. It remains as the provision for expenditure or fraudulent transaction. That provision is shown in the P&L account as losses after provisions which is adjusted against the reserves. There is a very clear methodology adopted for it. Accounting principles do not allow you to adjust anything against reserves directly. It has to go through P&L account because losses for the current year include these transactions.

Will there be a distinction between the Rs 6,500 crore that they have said they would pay out immediately at the end of the March quarter and the remaining account which will come due at a future date?

You have determined Rs 6,500 crore. Rs 4,500 you have identified, and you have to determine the full amount. It is more of semantics. You know that the entire liability is going to come. So, you have to provide only in the quarter in which you identified.

So, Rs 6,500 crore will be accounted for in the quarter ended March 31, and the remaining amount will be accounted for in whichever quarter those LoUs come for “fulfillment” and then we will see how those losses takes place in subsequent quarters. Is that fair understanding?

No. The entire Rs 11,000 will have to be determined in the current quarter. You will say in the balance sheet that Rs 6,500 crore has been determined, Rs 4,500 crores which are maturing in subsequent quarters are in process of the final figure being crystalised. You will have to provide Rs 6,500 definite and an approximate amount of Rs 4,500 crore. But in this case, the bank will know the exact amount. There is nothing which will change in the next quarters. It is mandatory for you to provide for it now.

As and when you recover from Nirav Modi or the entities involved, then you write back those amounts?

You can write back saying ‘recovered amount of fraudulent transaction’.

So, the full Rs 13,000 crore of fraud amount has to be accounted for in the March ended quarter?

Yes. Suppose if this transaction had been found in the first quarter, RBI could have permitted you after a disclosure to provide over four quarters. But you can’t escape the current year. You have to account for in the current year.

So, we are looking at very massive profit hit at PNB on account of it?

Absolutely, it is inevitable.

On the capital adequate side, will this impact CET1 ratio?

All ratios will get impacted.

In your assessment, where does the responsibility lie? Where should the regulators be looking at in terms of the responsibility of internal and external auditors in failing to detect this fraud?

I agree that it is very difficult for auditors to find out. We have the Harshad Mehta, Ketan Parekh, Satyam scams. Every time human ingenuity finds a new fraud, we all talk about the auditing community to improve.

If the auditors say that they are not responsible, investors would ask why have the audit at all.

The reason for the audit is to find out this. But to be fair to the auditing community, SEBI as well as the regulator must prevent the auditors from doing it in three days. It is an enormous ego trip for everybody to finish the audit in three-five days and print balance sheet on April 15. I don’t know why we should do all this. The problem is that shrinking timeline for audit and quarterly announcement of results is taking a toll on quality in audit.

The auditor has to continuously look for fraud prone areas, change the method of audit rather than saying the audit cannot find out. I agree today’s audit system may not find out, but investors are not worried about. If you can’t find out, then why conduct the audit is a legitimate question by the regulator and government and also by the investors. I think the auditing community will have to change the method of working and have to detect large scale fraud. I can understand Rs 10,000 having not been found as a fraud, but Rs 11,000 crore makes citizens of the country question where we are and what we are doing.