The accounting penalty-how complex to value Indian companies can avoid the low market valuations which they

face.

Presentation by:
Anandh Sundar Junior Member, Finance Network ShARE IIM Ahmedabad
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Executive Summary
Theory states that management has all the incentives to cook the books. Indias low rankings on any integrity or corruption index is accepted as routine Indias reported accounting scams are however few and scattered compared to rest of world Is this consistent with other economies with such a developed equities market? Does the market trust the book value? Low P/BV of industrial stocks show otherwise Sector specific factors and market cap appear to explain this phenomenon As even institutional investors get hoodwinked, retail investors shy away from direct participation in equities Will IFRS compound this problem and reverse earlier progress? How financial literacy and specialized post grad electives can make the difference How companies and analysts should respond to the looming transition, and make a fresh start.

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Theory states that management has all the incentives to cook the books.
The microeconomic theory
Diversified ownership and strong management People maximize their self interest People respond to incentives-the very basis of variable pay. Professional Management increases principal agent conflict

Does invisible hand Help here?

Information asymmetry between owners and managers Independent auditors supposed to help bridge that gap But questions about their expertise and independence.

The research says

There is no consistent evidence that equity incentives are associated with accounting fraud Even other research does not back up equity incentives as a causative factor, merely as something exacerbating other risk factors.

Llink between Equity Incentives and Accounting Fraud.

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Indias low rankings on any integrity or corruption index is accepted as routine

Ranking
Corruptions Perceptions Index

Measures

Indias position

Perception of corruption in public sector. 3.3 on scale of 10(1-most corrupt, 10 least correct). Mexico, Based on 10 expert institution views. Egypt and Russia fare worse but that fact is little solace. This Conducted by Transparency is relevant because public sector malaise slowly percolates International. down to private sector as well.

Protecting Investors The extent of corporate disclosures, With 6/10, India ranks 44(slipped from 41 earlier). The score ease of filing law suits and director is on part with OECD average and India scores well in liability. Subset of Ease of Doing disclosure and lawsuit ease, but poorly in holding directors Business rankings 2011 of World Bank liable. That is why few directors have been jailed yet.
Recovery Rate(%) The realistic recovery rates as % for creditors and other claims .). Subset of Ease of Doing Business 2011 rankings of World Bank Just 16.3%, even lower than South Asias 28% and OECDs 69.1%.. This would deter investors from backing a company with unsecured debt or equity, unless they have recourse to more tangible security. The SARFAESI Act has not improved things much on the ground.

Sourced from respective rankings. .

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Indias reported accounting scams are however few and scattered compared to rest of world
Rest of World
Famous examples are Enron, Lehman Repo 105, Tyco, Worldcom etc
Scams have been detected by hedge funds, researchers, analysts and employee tipoffs Regulators like SEC/FSA have proactively mandated restatements both pre-IPO( as in Groupon prospectus) and post IPO(in 10Ks)

India
Satyam Computers, Teledata Informatics, Reliance Communications(alleged).
Scam detection has been through self confession or through audit restatements. SEBI does not review annual reports. Only C&AG does so for companies under its purview, and has ensured quite a few restatements as detailed in its reports. Only Satyam perpetuators were jailed, not rest

Perpetuators like Kenneth Lay were jailed.

Is it because Indian academics and analysts do not focus on accounting fraud? While stopping short of fraud, some industries are aggressive in accounting like Airlines, Banking.

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Is this consistent with other economies with such a developed equities market?
UK had its South Sea bubble, with many others after that USA has a hallowed history of it right from 1880s till 2011. Chinese companies listed on NYSE(via reverse merger) have been accused by the SEC of widespread accounting fraud. Indonesia and other South East Asian economies were caught during the 1997 Asian crisis. INDIA????

Reports from other Developed markets

But there have been Very few bubbles to Let frauds surface

You only find out who is swimming naked when the tide goes outWarren Buffet quote. When a company is cash strapped(Satyam, Reliance Communications) or in a crashing sector(Teledata Informatics)-it then approaches third party bankers, investors and prospective buyers. When the liquidity tide goes out, then it easier to spot rotten books. Some small cooperative/private sector banks(GTB etc) were forced into shot gun mergers with bigger banks, before the spread fiurther. Banks could have collapsed after the Harshad Mehta crisis in the early 1990s but they were not allowed to fail.

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Does the market trust the book value? Low P/BV of 407 stocks show otherwise
P/BV of 0.03-0.50
144 companies. Notable names are Bharati Shipyard(0.32), DS Kurkarni Builders(0.33), Zicom(0.36), Alok Textiles(0.46), HDIL(0.46) and Ceat Ltd(0.47).

P/BV of 0.5-0.99
263 companies. Notable names are Hindalco(0.92), Tata Steel(0.9), Onmobile(0.89), Unitech(0.78), Deepak Nitrite(0.73), Essel Crop Care(0.71) and others.

Companies

Source of data-CMIE Prowerss

Data resources used from IIM

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Sector specific factors and Stock Specific factors seem to explain this phenomenon
Real Estate companies and Infrastructure companies are severely penalized for no apparent reasons. Maybe because the exigent accounting norms permit ample management discretion for technical estimates to inflate earnings. Highly leveraged sectors like textiles, shipping, retail etc are not in favour in the high interest rates scenario, given their low pricing power and consequential inability to pass it on.

Sector Specific Reasons

Fears of tunneling the cash flows lead to holding company discount as for Piramal Healthcare(0.49)-which is low given the usual 30%-80% holding company discounts prevailing in India. Stocks affected by scams(Teledata, GTL) are low, as are those with pledged promoter holdings.

Stock Specific Factors

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As even institutional investors get hoodwinked, retail investors shy away from direct participation in equities
Institutional investors held 8.4% on average in those 407 companies They held 6.6% in companies with P/BV<=0.5, and 9.4% in companies with P/BV between 0.5 and 0.99. The lower holding of 6.6% could mean smarter investing, or just that the sell orders were triggered when those companies began hitting the lower circuit In 54 of those companies, institutional investors held more than 20%. Individual investors perceive that institutional investors perform due diligence before investing in companies. However, herd mentality and limited investor universe(due to liquidity, size and other considerations) may get the better of that During quarterly conference call transcripts, it is seen that questions are more related to housekeeping(variance analysis, breakup of balances) or factual based instead of incisive questions on strategies, deficient disclosures Investor folios reduced from 40 million in Mar-09, to just 38 million now In Mar-11, retail investors hold 16% of 2500 odd actively traded stocks on the BSE, which is lesser than the 19% they held in Mar-06. This is despite the regulatory push(SEBI, IRDA, RBI) for more transparency in the system and increasing campaigns for investor awareness.

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Will IFRS compound this problem and reverse earlier progress?

IFRS allows ample discretion compared to US GAAP or Indian GAAP To partly compensate, it mandates voluminous disclosures These disclosures are filled with accounting and legal jargon, making it difficult for anyone but a skilled accountant to read between the lines Nowadays, few equity research analysts are Chartered Accountants, with most being CFAs and/or MBAs Will they pick up the requisite accounting skills in time? More importantly, is there enough training bandwidth? Will scams during the transition period(say FY12-FY13)-due to the poor marcoeconomic environment erode investor confidence?

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How financial literacy and specialized post grad electives can make the difference
NSE has tied up with colleges and MKCL(Maharashtra Knowledge Corporation Limited) to introduce a basic financial literacy program, which covers the basics of financial planning and investing The investor education and protection fund(IEPF)-funded by a transaction cess on exchange turnover-funds investor seminars, advertisement, booklets, research and publicity material. These aim at explaining concepts and warning investors not to get misled by boiler room operations, research reports, pump and dump etc At the professional level, NSE has tied up with Thapar University for a joint 2yr MBA program. The Central Govt promoted NISM(National Institute for Securties Management) has fulltime and distance education programs to build capacity in the sector. Also, private organizations like FLIP are entering this space. With specialized modules like equity research, corporate analysis etc, more practical education may help professionals become better analysts.

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How companies and analysts should respond to the looming IFRS difference and make a fresh start
Realize the additional volatility induced by IFRS Mark to Market fair value norms, and find ways to measure and communicate it well. Take the opportunity to reengineer the accounting, MIS and investor relations processes, to meet best practices. Improve understanding of the company with multimedia(plant videos, project photos etc) so that stakeholders appreciate the risks and do not overreact to adverse disclosures.

Companies

Analysts

Scrutinize company proforma metrics and compensation targets, for any accounting jugglery(like not excluding exceptional income etc) Realize that the IFRS induced P&L volatility will make forecasting much more tedious, and therefore not to downgrade a company for failing to make the consensus numbers. Demand and take benefit of IFRS education workshops. Understand the critical disclosures under IFRS(risk management, derivatives, revenues etc) and penalize companies which fudge them or try to drown the relevance with useless boilerplate. READ the entire filing(even though 100+ pages) instead of just looking for the numbers. Remember Enron SPVs were apparent from filings.. 12

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Thank You

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