Forensic Clean-up | Value Research The economic downturn was a dark cloud, but had its own silver lining too: cleaner account books in India
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Forensic Clean-up

The economic downturn was a dark cloud, but had its own silver lining too: cleaner account books in India

Some journeys are hard to forget as they mark a watershed in our lives. I made one such journey in the summer of 2008.

It was August 2008 and having recently migrated to India from the UK, I was flying from Mumbai to a southern Indian city to meet the CFO of one of the leading power and construction companies in the country. With me was our power sector expert. Throughout that journey we tried in vain to make sense of that power company's balance sheet, a balance sheet which contained a high quantum of "Loans" in, both, assets and liabilities. Loans taken by this company amounted to as much as its shareholders' equity. Even more interestingly, money lent by the power company amounted to 1.8x its shareholders' equity. Why was a power company lending so much money? Who was it lending that money to?

Three hours later I got the answer after questioning the CFO, first politely over lunch and then more intensively in his office. The money was being lent to various shell companies. Those shell companies then took equity stakes in the power plants that the power company had won tenders for. Each of these power plants was in a Special Purpose Vehicle (SPV) which then gave the "construction" order to the listed entity. Thus the loans advanced by the listing entity were also being accounted for in the listed entity's P&L as revenues and hence profits. These profits obviously boosted the listed entity's shareholders' equity which allowed it to borrow more money from the banks and that in turn allowed it to finance more power plants (for which the construction order would come to the listed entity). And thus this insane spiral, which looked to me to be a contravention of Accounting Standard 21 (pertaining to consolidation of accounts between related parties), continued.

It took me another week to understand the full extent of this accounting shenanigan not just in the company in question but more generally in the power, infra, construction and real estate sectors in India. Having realised how widespread this practice was and how it was being used to give a misleadingly flattering picture of the financial health of these companies, I decided in the autumn of 2008 to make forensic accounting a key specialism of the teams that I worked in.

As luck would have it, three months later in December 2008 I co-authored a note highlighting that Satyam's accounting and governance looked peculiar. A fortnight later, after Ramalinga Raju's infamous admission of guilt, our forensic accounting work became a staple for institutional investors – both domestic and foreign – deploying capital in India.

Four years on the demand for such analysis has become so high that the team that I work in contains 15 chartered accountants (each chosen after an intensive interview process focusing on forensic accounting) and 6 CFAs (financial statement analysis is one of the key strengths of the American CFA program). Our analytical skills are in such demand that we regularly have to turn down requests from large Indian and foreign banks to help them identify fraudulent corporate borrowers.

Most investment committees in Indian and foreign asset management firms now make it compulsory for investee companies to be subject to rigourous accounting analysis. As a result, we find that the correlation between accounting quality and investment returns is gradually tightening. Our statistical analysis shows that within most sectors in the Indian market, accounting quality alone is responsible for 30-50 per cent of the share price movement shown by stocks. When I began work in India in summer 2008 such a correlation was not at all evident.

Corporate India too is changing in response to this heightened awareness of accounting quality. Whilst I still get a nasty call or two from Indian corporates who don't like being put under the scanner, many corporates have used the FY11-13 downturn to clean up their act by writing down non-existent assets and imaginary revenues. Although this superficially heightens the impact of the ongoing economic downturn, the gradual move to more conservative accounting practices is a major long term plus for the Indian market. In contrast to some of the East Asian stockmarkets such as China – where forensic accounting still hasn't found strong roots – Indian companies' accounts are arguably cleaner now. In this, as in other spheres of life, evolution, rather than revolution, works quite well in India.


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