Variable pay causing profit & loss variations

Deepankar Sanwalka, the head of forensic services at professional services firm KPMG, and his team are investigating a dozen cases of senior management fraud at the moment. Many of these cases relate to shoring up profits with the aid of fraudulent and unethical practices.

A year ago, Sanwalka had on his plate not more than six such cases. Referrals have been rapid in the last few months. Looking ahead, he expects his services to be in great demand.

As the economic slowdown worsens and the strain rises on profits of firms, businessmen, investors and auditors have started grappling with a new headache — attempts by chief executives and other vertical heads to dress up the profit & loss statement.

There is a temptation to book profits by hook or by crook because their variable compensation is linked to profits. In some cases, the variable compensation can be as high as thrice the fixed compensation.

Citing client confidentiality, Sanwalka refuses to divulge the details of the cases he is investigating. A large multinational is known to have changed its entire top management recently after it was found to indulge in financial impropriety. Industry circles are abuzz with more such cases that have recently come to light.

Several auditors and corporate lawyers Business Standard spoke to said it was a matter of time before more such cases tumbled out of the closet. “It is a result of how compensation is structured. It has happened in the US and I see no reason why it won’t happen in India,” said Rajiv Luthra of law firm Luthra & Luthra.

Still, most experts agreed that the dirty linen was unlikely to be washed in full public view. “Companies in India are not very transparent. Firings are always masked as resignations,” said K Sudarshan, the managing partner of EMA Partners, a headhunting firm.

In the last downturn, which occurred in the early years of this decade, several cases of fraud were unearthed all over the world. At that time, corporate fraud was driven by stock options — executives shored up numbers artificially to keep share prices high. This time, the culprit could be profit-linked compensation.

Common tools used by senior managements to shore up the company’s bottomline, according to auditors, include not capitalising fully the investments on the company’s books, transferring expenses to subsidiaries, and pushing stocks to dealers from their own warehouses.

The threat is serious. “In most referrals, we find that the crime has indeed been committed,” said KPMG’s Sanwalka. “Auditors and business observers need to be more careful in a downturn,” added PricewaterhouseCoopers partner Kaushik Dutta.

In most cases, the whistle is blown on such malpractices by promoters and audit committees of directors. Increasingly, such investigations are also being initiated by private equity investors sitting on the boards of companies. With the equity market down in the dumps and debt turning costly, a large number of companies have turned to private equity. These investors, in turn, demand better corporate governance.

According to EMA Partners’ Sudarshan, cases of financial impropriety are more likely to take place in professional-driven local arms of multinational corporations, rather than promoter-led Indian companies. “Professional managers are more likely to sign the balance sheet in a multinational corporation than an Indian company,” he said.