India Inc's corporate governance hits a new low

“To state the facts frankly is not to despair the future nor indict the past. The prudent heir takes careful inventory of his legacies and gives a faithful accounting to those whom he owes an obligation of trust.”
                                                                          –   John F Kennedy

CNBC-TV18s Research Analyst, Haresh Soneji

Alright, the earnings season is over. India Inc. posted a dismal profit after tax (PAT) growth in the Jun ’08 quarter over the Jun ’07 quarter. But, reported PAT is full of extreme ‘window dressing’. The moral of the story is – don’t take India Inc.’s Jun quarter numbers on face value. India Inc. appears to be juggling itself through powerful financial engineering, which is all very legal. The biggest problem however, is perhaps the hit India Inc. is taking on its corporate governance. This is certainly bound to tarnish India Inc.’s reputation among foreigners. Corporate governance – something that India Inc. cherished compared to its emerging market (EM) peers is now hitting a new low. And that won’t help valuation multiples in India.

India always commanded a premium to other EMs, a part of it on account of good corporate governance. This premium is in the process of diminishing and could shave off some 150-200bps on earnings multiples. So, valuations backed by weakening earnings could further inch downwards. For the naysayer, let me assert the current pull back in the equity market is a bear market rally on all possible counts.

And how exactly is corporate governance weakening? A lot has to do with accountants burning the midnight oil. A deeper look at India Inc.’s scorecard would show how accounting policies are used effectively to spruce up the bottomline. So, even when India Inc.’s earnings have grown a mere 13% (1,239 companies ex-oil & financials) during Jun ’08 over Jun ’07, the real situation is actually a negative growth in earnings. In fact, sequentially the absolute profit numbers have shrunk.

Let’s see how accounting policies helped India Inc. sail through the Jun ’08 quarter. For instance, the new accounting norm AS-30 (Financial Instruments Recognition & Measurement) aims at providing for losses on forex derivatives in P&L account. The problem however is that it becomes effective FY11. So, India Inc. has capitalized losses for now. Next, India Inc., under the assumption of compulsory conversion, has not recognized forex losses on FCCB conversions. Third, change in depreciation policies has pushed up profits. Fourth, assets have been transferred to subsidiaries without any clear valuation methodology. These are just some of the various methods used by India Inc. These are governance issues as they don’t present the real picture of India Inc. In short, India Inc. has managed to sail through with a lot of financial jugglery. 

Having said that, signs of slowdown are definitely worrying India Inc., but deep down under India Inc. doesn’t want to buckle under pressure. When we spoke to a some companies it appeared that most of the management continued to be optimistic of the near term trend. We think, they have no choice but to be bullish, at this point in time. But, increasing cost of borrowings and deferring capex, among other things show weakening confidence. To top that, India Inc. can’t continue increasing prices. Experts have started talking about demand destruction. It’s more likely a reality than talk. Some of the sectors such as auto and construction are already facing it.

To conclude, if India Inc. continues with such practices we may have to see further pain over the next few quarters. It’s not going to do any good in the long term. The faster India Inc. moves away from its financial jugglery, the better. The billion dollar question is ‘Is India Inc. listening’?

Disclosure: The author is not permitted to trade and/or invest into the equity market directly or indirectly, apart from investing (long only) in mutual fund products. His equity exposure is only to the extent of ESOPs granted by the employer.