Sound corporate governance doesn?t always need shareholder activism. Market forces should also press for best practices and that should reflect in the valuation of a company. So, does sound corporate governance impact the valuation of a company? The answer is a resounding yes. Sound corporate governance practices have always been seen as a positive by the lenders of capital, be it the banks or even the capital markets.
According to Gabrielle O?Donovan the author of, A Board Culture of Corporate Governance, ?The perceived quality of a company?s corporate governance can influence its share price as well as the cost of raising capital. Quality is determined by the financial markets, legislation and other external market forces plus how policies and processes are implemented and how people are led.?
In the early 1990s, sound accounting policies could actually be farcical. Rampant inter group transfers and revaluation of assets, all as per the book, was commonplace. Window dressing techniques were rife and used extensively.
Increased globalisation and exposure to the US and UK accounting standards has meant that the books would be under more scrutiny. The opportunit of being bought overies at handsome prices or availing private equity has encouraged more and more promoters to clean up their act.
However, with things getting tough this year, a lot of corporates have started resorting to accounting practices that challenge the tenets of sound corporate governance. Some of these include changes in depreciation policy and revenue recognition policy to buoy profits or revenues. Then there are several cases of transfer of assets to subsidiary companies or group companies to boost stand alone profits and without any clarity on valuation methodology or justification of the same, noted a CLSA study in August this year.
Capitalisation of foreign exchange losses on foreign exchange debt and forex contracts is being observed. Exchange losses on translation of FCCBs not being recognised under the assumption that FCCBs will necessarily be converted is another practice. And, losses on outstanding foreign exchange derivatives, while being disclosed, have not been provided for in the P&L as per AS-30, most companies do not follow AS-30 as it becomes effective from 2011, the CLSA study observed.
Jet Airways changed its depreciation policy from written down value method to straight line method and thereby wrote back Rs920 crore into its P&L, which helped the company to report profits during the quarter. In another case, Tata Motors transferred 24% stake in Tata Automotive Components (TACO), a company with a small revenue stream to Tata Capital, a group company, and booked profit of Rs 110 crore in 1QFY09. There are more instances.
Now, all of this will take a toll on the valuation metrics. Indian companies have built a reputation for sound corporate governance and hence attracted a premium in the global market place. And the risk of losing this premium status is now very high. The CLSA report concludes, ?In a scenario of rising risk aversion, investors will take a tougher view on companies that adopt ?aggressive? accounting policies, even if these are in line with prevailing accounting standards. This will reflect in the de-rating of such stocks, relative to peers that adopt ?conservative? accounting policies.?
A steady reputation created by the efforts of several companies could well be damaged. And this could add to capital costs. The risk that India Inc. now runs is significant. They ought to move towards more transparency rather than less. Otherwise market forces may enforce the penalty.