The meltdown in financial markets is pushing some companies, especially in the small and medium enterprises segment, to take up ?aggressive? accounting practices, that is often pretty close to outright fraud. The aggressive practices include reporting abnormal shifts in inventory levels and sharp changes in entries for debtors and creditors.
Private equity funds and overseas companies have noticed the trend and have stepped up vigilance by hiring top consultancies and auditing firms to check the balance sheets more intensively. Some of them have pulled out of contracts as well.
?The level of frauds has shifted, from employee to the promoter level,? says Navita Srikant, partner, frauds, disputes and investigative services, with Ernst & Young. She is investigating three companies for window-dressing of books. The flashlights for taking up such exercise is typically when inventory levels of a firm change like a yo-yo or fluctuate abnormally, indicating that promoters are possibly cashing out.
Vidya Rajarao, executive director, PricewaterhouseCoopers, who handles investigations and financial forensics, narrates an incident where an Italian company had formed a joint venture in India, with each partner holding 50% shares. Within a couple of years, the Italian partner observed huge cash losses in the JV, which was pretty surprising as this ran against the trend in that industry.
She adds, ?Our forensic experts within a short span of two weeks determined large value of fictitious purchases recorded in the books of accounts, over-payment for purchases, under-billing for certain sales invoices and siphoning of inventory by the Indian partner. Based on our findings, the Italian partner has initiated legal proceedings against its Indian JV partner.?
Navita Srikant attributes this to the fact that there has been a change in the economic circumstances where funding and expanding is getting tougher than before. This has prompted companies with thin wallets to resort to window dressing.
CLSA Asia Pacific Markets?, which advises a large set of investors, has mentioned the growing concern towards window dressing. ?In a scenario of rising risk aversion, investors will take a tougher view on companies that adopt ?aggressive? accounting policies, even if these are sanctioned by law and in line with accepted standards.? It further adds, ?This will reflect in the de-rating of such stocks, relative to peers that adopt ?conservative? accounting policies. Indeed some of the stocks have already been de-rated significantly?, the report says. While the report is not specific to India, it mentions that a reason for Indian stocks attracting a premium amongst other Asian peers so far has been its strong corporate governance practices. This has meant superior disclosure along with high earnings growth. That earnings growth would smoothen out has been factored in by the institutions, hence, corporate governance and disclosures have become critical differentiating factors.
Foreign institutional investors have been large sellers in the Indian stock market this year. Private equity investments have also shown signs of a slowdown. A Grant Thornton report mentions that the total number of PE deals during the first seven months of 2008 stood at 215, with an announced value of $7.74 billion as against 224 deals amounting to $9.52 billion during the corresponding period in 2007.
The sharp practices could hit the SME segment hard, reckons a private equity fund manager with a multinational firm, as they are the most vulnerable to the swings in financing plans.
According to him, about 90% of such investments are in the SME segment, typically in growth-oriented companies, which are funded in the range of $20-50 million.