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In the wake of the Satyam scandal, which could open a can of worms, market sources say foreign investors are not only taking a hard look at the accounts furnished by Indian companies, but also asking brokers to run forensic accounting checks.
“The Satyam scandal has come as an electric shock to foreign investors and they are actively reassessing the Indian markets, trying to figure out to what extent is Satyam a part of the larger story of deficiencies in Indian corporate governance and Indian accounting malpractices,” said Saurabh Mukherjea, head of Indian equities for the Noble Group, a U.K.-based research firm catering to several leading investors in India.
“Ever since the Satyam scandal broke out (about two weeks ago) we have been flooded with requests from FIIs to vet their portfolios for irregular accounting,” Mukherjea said. “They are not only asking for intensive forensic checks but are also conducting independent checks with ex-employees, peers and industry sources to ensure that they do not get burnt by another Satyam.”
Even if cooking accounts is not unusual in global business, and certainly not in India, barring the mea culpa from Satyam-founder Ramalinga Raju, no other corporate malpractice has revealed the gaping holes in accounting and auditing practices prevalent in the country.
Analysts say that over one-fifth of the top 500 companies listed on the Bombay Stock Exchange are managed and controlled by individuals or families who do not own majority stakes in the companies and often siphon off money.
“I can’t name them, but few managements are clean in India,” said Mayur Joshi of India Forensic, a fraud examination and forensic accounting consultant. “And financial statement manipulation is one of the biggest sources of committing fraud, while others like tax evasion and rigging share prices are also rampant.”
Noble’s Mukherjea has even listed some favorite techniques that unscrupulous managers adopt. One is labeled “pump and dump,” where managements “pump” up the stock with the objective of generating liquidity and interest among market participants. Once the volume as well as the share price is pumped up through a series of positive announcements, the manipulator dumps his holdings. Various investigations have highlighted this pattern repeatedly and “this abuse is probably as old as the stock market itself,” says Mukherjea.
“Blab and grab” is another technique through which managements can pull the wool over unsuspecting eyes. This involves the announcement of a new venture related to a “hot theme” – and often unrelated to the company’s core competence – with the intention of raising cash. After the funds are raised, the new venture is intentionally forced to the back burner by way of “postponement due to delays beyond control.”
And, like Raju’s infamous tool, expense manipulation flourishes in India too. Indian managements deploy this technique to suck out cash by inflating innocuous expenses like “sales and distribution expenses” or “miscellaneous expenses,” which typically form a very small percentage of total operating expenses and remain concealed from prying eyes.
According to Mukherjea no specific size or sector biases exist, as “accounting irregularities exist across the board and across a range of sectors in the Indian markets.” However, a study of 1,200 companies by India Forensic has found that the manufacturing sector is most prone to fraud. “This sector constitutes more than 26 percent of fraud across the 11 sectors we studied,” said Joshi.
Property and real estate is another sector notorious for cooking books. And notably, despite the fact that an information technology company revealed India’s biggest fraud, “creative accounting is not a widespread malaise in the country’s IT/back office sector,” said Ganesh Natarajan, president of the National Association of Software and Services Companies, the IT lobby.
“Obviously one can’t vouch for all companies in the sector, but by and large if you look at large companies there are no such issues,” said Natarajan. “Moreover, following Satyam, NASSCOM is taking steps to ensure that all its members come forward with the highest level of disclosures.”
Still, the Satyam scandal has been “the most drastic and embarrassing scandal for corporate India,” said the India head of on foreign investor, who requested anonymity. “The fear is that there will be more going forward, which is why one has to be a lot more careful while assessing an investment decision in the country.”
According to Noble, a big reason why the skeletons have now started tumbling out of the closet is because previously India never had a period of weak economic growth coinciding with heavy foreign investment. After all, even as India experienced 5 percent plus growth in gross domestic product in the past, foreign investors have had a very small stake in that prosperity.
But with India’s growth story attracting global attention over the past few years, foreign investors are now significant holders of Indian equities, owning an estimated 10 percent shares in companies listed on India’s National Stock Exchange.
“Clearly, this is going to be India’s first encounter with weak economic growth with greater FII participation,” Mukherjea said, “and a learning phase as well for both sides. Indian companies will have to learn how to deal with large finicky investors, and finicky investors will have to learn how to assess Indian firms and grill managements in a tough economic climate.”
An interesting dichotomy observed by Mukherjea is that, despite the problems of accounting methods and corporate governance, Indian share prices are also the cheapest in five years.
“A lot of flak is already in the price and if careful investors are willing to do their homework, attractive investment opportunities can still be found,” he said.
