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Scrutiny for some sectors

MARKET INSIGHT

Devangshu Datta  |  New Delhi 

Satyam's cooked books could raise questions about sectors, which can inflate export income because of tax breaks.

When I wrote about Satyam last week in this column, there was no inkling that the balance sheet was one gigantic multi-year fraud. Even now, the sheer scale is tough to comprehend. At Rs 20, mid-way through trading on Friday, the Indian share presumably has much more downside since the ADR dropped to the equivalent of less than Rs 5 before the NYSE froze trades.

It may take months or even years before we learn what can be rescued from the wreckage. There are genuine revenues and perhaps, some profits as well. It has ongoing contracts. Perhaps business divisions can be spun off as going concerns? Perhaps it can be sold to an asset stripper?

Due diligence will be an interesting exercise. Class action suits have already started with claims from all quarters. There is a clash of jurisdictions that could make for interesting case-law. Fresh audits will be a nightmare. Every asset will have to be verified painstakingly given that the promoter suggested line-items are wrong by factors of 10x. One hopes the employees (are there really 53,000?) will emerge without too much pain.

But this imbroglio only strengthens the argument one made earlier for empowering market forces. It shows a signal failure in the approach of trying to impose higher standards of corporate governance through the appointment of independent directors, etc. Clause 49 is copied from legislation that failed to stop Enron and World Com from pulling similar, much larger scams. In those instances, as in Satyam, “big four” auditors let “creative accounting” continue over a period of years.

One lesson is, if a company is prepared to lie big, it will probably be believed. Another lesson is, it will eventually go down the tubes because the market will sometime or the other get an inkling that something is wrong.

Unfortunately fraud on such scales cannot be picked up by examination of the balance sheet. If the auditor certifies that assets including cash balances exist, any analyst must perforce believe them. Satyam’s cooked margins were believable – 24 per cent OPM is at the lower end of the scale for big IT service companies. The act was so good that it won a global award for corporate governance.

The fallout from something like this is massive, generalised loss of confidence in the financial accounting system. In such situations, the credibility of management becomes paramount. An Infosys, TCS or Wipro gains because the people at the helm have built a reputation for being honest over decades.

The biggest losers, apart from those directly impacted as shareholders and stakeholders of Satyam, are investors in companies with less credible managements. The scepticism will translate into lower PEs.

Satyam could inflate profits at will because it didn’t have to pay IT on its export income. Other exporters may try similar models of creative accounting due to similar patterns of tax exemption. It’s also likely to happen in other industries with tax breaks.

It’s more common to deflate profits and siphon cash off. In businesses where the cash component is inherently large, PEs could hit the floor. For example, liquor, aviation, FMCG, retail, are all cash-businesses with a large proportion of revenues accruing in cash transactions. That gives managements the incentive to develop cosy relationships with the IT and excise departments and conceal cash revenues. Inflating profits is less likely in such businesses where taxes are payable on profits.

Real estate works on the concept of net asset values and land banks. There is always a subjective element in such valuations, and there is often a large unreported cash component on all legs of real estate transactions. Cynics would assume official numbers are meaningless and price real estate developers down.

Indeed, real estate stocks got hammered on Jan 7 and 9. Will we see similar trends in other businesses where it’s relatively easy to cook the books? Chances are, yes. Logically, if the market responds to the Satyam fraud by permanently slashing PE discounts on all companies with potentially questionable financials, it presents an interesting challenge for managements.

Do promoter-managers steal or do they try to build credibility that translates into better valuations? Those who want to make a quick buck will take one route while the really smart ones will take the longer, more painful but ultimately more rewarding route.

First Published: Sun, January 11 2009. 00:00 IST
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