Rating Agencies and Accounting Firms – fixing the responsibility?

The first session of corporate governance course started on a good note, why am I terming it as ‘good’, well was some good participation from each corner of the class. During the discussions the prof. made a point that accounting frauds and false rating by rating agencies are some of the important challenges while addressing the concerns of corporate world. Well, people sounded that it is difficult to penalise monetarily the accounting and rating agencies and usual norm is to rotate the accounting firm periodically (the regulation that came in after Satyam) and refer to credit rating of a firm by multiple rating agencies.

Yes, it is difficult to quantify the penalty that should be applied to accounting or rating agencies because they are not running the business, they are dependent on the managers to provide them with the necessary documents (that too only when asked), and that the size of the client company can be even 100 times the revenue of these accounting firms and rating agencies. We cannot ask these to compensate for the fraud in these big firms, the accounting and rating agencies will go bankrupt in just 1 fraud incidence. But does that means there is no way to make them liable, financially responsible for the fraud that could have been averted by ‘due’ due diligence by these firms.

I am not sure if there are already some experimentation done in this regard in some corner of the world but surely one can come up with some logical and acceptable solution.

You can make these firm pay for the proportionate amount of their own worth in terms of damages if there happen to be a fraud e.g. an accounting company with Rs 100 crore in revenue, acting as a accountant for a Rs 10,000 Cr company. Take a case that the client has done some fraud amounting to Rs 5,000 Cr, then the accounting firm should be made liable for 50% of its own worth i.e. it should be asked to pay Rs 50 Cr in terms of damages to the affected stakeholders.

Now the above argument can be contested on the ground that the accounting firm can have 10 different clients and out of which only 1 did a fraud so it is wrong to penalise the firm solely taking into account the fraudulent firm. OK lets modify the above statement a little bit, lets the total worth of all the clients of the accounting firm is Rs 1,00,000 Crore and 1 firm did a fraud of Rs 5,000 Cr in that case the accounting firm can be asked to pay Rs 5 Cr in damages. Well this can be very well too small for a accounting firm and may not make a significant threat!!!

Let us look at it differently, say that the same accounting firm has earned a total of Rs 50 Cr (present value) in term of fee towards its accounting services for the fraudulent firm. One can straight away ask the accounting firm to pay the same in damages.

Similar ideas can be put down for rating agencies as well and the final solutions (just and acceptable) can very well be a combination of the above three points or may be altogether a better option. But fixing the liability in financial terms is quite possible and can be done. May be there exists some sort of formulae that even I am not aware of; and the whole effort that I have put in while writing this is useless!