A forensic report prepared for the Serious Fraud Investigation Office (SFIO) shows over a third of India’s top 500 companies, including those in the top 100, are “managing” their accounts.
It finds that companies where promoters hold more than 50% of total shareholding are more likely to take such steps to impress markets with their performance. Both domestic companies and subsidiaries of multinationals listed in India show similar trends when their shareholding is concentrated in a few hands.
The report by rating agency India Ratings, part of the Fitch Group, is the first which raises questions on the overall health of the corporate sector. It is buttressed with extensive statistical analysis.
It has created consternation within the government for two reasons. The report notes that almost all companies whose financial numbers are questionable underreport tax liabilities. Also, all such efforts have been approved by the board of directors of these companies, raising questions about the effectiveness of corporate governance norms in some boardrooms.
Speaking on the report, lead author Deep Mukherjee notes “the possible incentives of management to manage these earning numbers could be to meet market expectations”. The agency analysed data for BSE 500 companies going back up to 12 years to figure ways how the numbers are managed.
The report also states that audit by four big firms of these 500 companies is not necessarily superior to that of homegrown auditors to catch these aberrations. A top revenue department official told The Indian Express they are also studying the report and have commissioned an agency to examine the revenue angle further.
Among sectors, FMCG, pharma and automobiles are more likely to see such aberrations since these companies have significant controls over their supply chain partners. “In an economic downturn, these weak players (partners) may be made to bear the brunt of the slowdown so as to insulate the earnings of large players,” the report stated.
“Questionable operational practice” followed by many companies also include those on depreciation, interest cost, employee cost and selling and distribution expenses besides their tax scores as shown in their financial statements.
Some auto companies resort to “channel pushing, that is supplying finished goods to distributors so as to book higher revenue during year or quarter end”. It argues for caution in giving weightage to inter-company loans. “One may be cautious of companies, where a significant portion of the promoter holding is pledged for promoter loans.”’
There are significant numbers of black sheep in the BSE 100 list too. While it does not offer any details, an independent source, analysing the financial statement, notes that the total number of such companies is above 15.
“The fact that a corporate has market capitalisation in the top 100 does not necessarily mean that the quality of financial reporting is among the best in the class… many mega cap companies have entered into financial distress or have fallen from grace with alleged corporate governance violation,” the report states.
Using stiff statistical tests, the report finds that the common “discrepancy” resorted to by some of these top companies is in reporting their interest payments due and of their profit after tax.
Surprisingly, companies that are smaller, the mid caps, tend to have better quality of reporting their financial numbers. “Corporates ranking between 101-200 in market cap have relatively the least discrepancies in financial reporting, as per the statistical tests.”
The report builds on an analysis made in a Sebi-commissioned research project in 2013 that looked into earnings, management practices of Indian companies as well as an Indira Gandhi Institute of Development Research paper.
Both surveyed a larger number of companies but for less number of years to arrive at similar conclusions.
All these reports argue that when the economy takes a nose dive, these trends rise. “Since some of these earnings measures form components of credit metrics and any deterioration of metrics could trigger a covenant breach”, the Ind-Ra report states.
The antidote to keep companies off such mischief, the India Ratings report notes, is to bring in more pension, insurance and mutual funds into the boardrooms.
Deep Mukherjee notes that since promoters often have large pledged shares “they could present a less than accurate representation of the health of the company” to keep up share prices. Institutional investors, as the report notes, will not accept such window dressing.
Because of the sensitivities involved, the credit rating agency has qualified its report at several places. “Flagging a variable does not necessarily imply fraud but indicates a statistical possibility that it may have been biased or managed willingly or coincidentally”.
It also refuses to take an alarmist position stating instead “if a significant number of variables are flagged off in some of these sectors, it is not implied that all corporates in the sector would have an issue with financial reporting. Each of the sectors may have several corporates with high quality of financial reporting and disclosures”.
M Damodaran, former Sebi chief, said he wouldn’t agree that promoter shareholding is an issue. “Of more salience is the role of independent directors. High quality independent directors and not just marquee names are critical along with presence of strong audit committees to ensure numbers are faithfully reported.”
For shareholders, the report concludes that compared with data like profit and revenue numbers, investors in all companies would be better off by studying cash-based measures. These are cash flow from operations and fund flow from operations. Also, companies that have taken on additional debt would be safer. It is because companies which borrow from banks or from abroad face added scrutiny from those borrowers and rating agencies.
Jagvinder Brar, partner of forensic audit business at KPMG India, said their analysis of company-wise report cards have begun to throw up identical issues. “The Reserve Bank of India needs to write in a stringent and comprehensive right to audit and inspection clause in bank loan contracts.”
Sandeep Parekh, former executive director of Sebi and founder of Finsec Law Advisors, said he agreed that loss recognition practices don’t alter much between Indian and foreign firms. “Instead it is companies with wider shareholding that would have the incentive to demonstrate transparent business practices.”