Recently my colleague, Bhargav Buddhadev, and I published a study showing that the quality of accounting has improved in India in the year following the Satyam-scandal. We rationalise this finding on the basis that with the stock market being in the depressed state that it was in FY09, the incentives to massage earnings were muted. Moreover, in an economic slowdown, such as the one seen in FY09, revenue and earnings growth is bound to slowdown and that reduces the scope for accounting tricks. Finally, based on what we heard from the audit community, we cannot rule out the possibility of creative accountants losing their nerve post-Satyam.
Three specific findings which emerged from our forensic accounting analysis surprised us:-
1. Large caps are deceptive: In FY08, large caps were the least risky segment of the market with the probability of a top 50 company (by market cap) finding its way onto our “blacklist of 50 worst companies” being 9%. In FY09, this probability had doubled to 18%. So in the space of a year, large caps went from being the least risky to being the most risky segment of the market. When we dug deeper, we found that on the accounting parameter on which the broader market had improved the most in FY09, cash conversion (i.e. the ability to turn profits into actual cash), the top 50 stocks had actually gone backwards in FY09 suggesting that some of India’s blue-chip stocks might be burning the midnight oil with their accountants.
2. Housing is a consistent outlier: In both FY08 and FY09, a single sector – Housing – constituted around 20% of our “worst 50 blacklist”. We stopped feeling surprised about this when we realised that the BSE (whose sectoral definitions were used for our analysis) defines “Housing” to include Real Estate, Construction and Cement stocks. For a variety of reasons (eg. the ability to book revenues well before a project is completed, the variety of expense items that can be capitalised, the ability to use SPVs to generate phantom revenues), Real Estate related companies enjoy enormous latitude when it comes to accounting.
3. Expense fiddles continue: The one accounting fiddle that makes sense in a bear market is cash pilferage via over-invoicing (to friends and relatives) of expense items clubbed under “other expenses”. We found that the ratio of “other expenses:revenues” rose 1.2% points in FY09 (despite revenues rising by 21% in FY09 for our dataset and despite the tough economic conditions prevailing that year).
Having listened to a summary of our findings, one of our clients asked us, “Does any of this really matter? After all, isn’t it well known that lack of ethics can be a good thing in an emerging economy like ours.” So do corporate ethics really matter?
In Emerging Markets, it is probably unhelpful to search for management teams populated with saints since, to a considerable extent, the psychological characteristics required to be a successful entrepreneur in these markets do not lend themselves to spotless corporate governance track records. In fact, the question, “Are unethical companies good investments?” is not very interesting in the context of Emerging Markets because it is well known that unethical companies can be market beating investments for a variety of reasons (eg. they might have lower costs by flouting environmental restrictions, or lower tax payments by avoiding taxes, or privileged access to powerful politicians).
Even the question, “Can lack of ethics be turned into a sustainable competitive advantage?” is unlikely to intrigue Indian investors who know that certain companies have over the last 20 years shown that they can repeatedly influence the political and bureaucratic elite.
However, that still leaves two critical questions unanswered: (a) Will companies who are unethical in their pursuit of profits suddenly become ethical when it comes to giving shareholders a fair deal?; (b) Will companies who are unethical in their pursuit of profits become victims of other equally unethical companies?
The relevance of these questions in light of the events of the past year (and I am not just referring to Satyam) has convinced us that it is worth using forensic accounting to identify dodgy companies. Whilst the seductive share price performance of such companies is a strong lure, with the “capital raising window” wide open at present and with the stockmarket roaring away, corporate India’s incentive to resort to creative accounting in FY10 are greatly heightened in comparison to FY09.
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