With the end of November of 2008 came India’s own 9/11; and with the dawn of January 2009 was born India’s own Enron (or WorldCom if you wish). While the two events are not comparable at all, they do have one common causal factor – the failure of governance and administration at the helm. Both tragedies have impacted the unsuspecting and the innocent the most, but those who are accountable and responsible are yet to take stand in the courts of justice.
In the particular case of Satyam, an expectation of legal proceedings commencing this early might be premature; however, it is probably high time that corporate governance reforms are implemented in India. Given that Clause 49 of SEBI’s[1] listing agreement already calls for measures akin to the Sarbanes Oxley (SOX) act of the US, is there any further room for regulatory improvement? A brief analysis underscores a few avenues where further amendments, to increase the corporate governance and transparency standards, are possible.
To begin with, independent corporate governance assessment (CGA) and its disclosure should be made mandatory for all listed firms.[2] While this might seem an extreme reaction, it will have an impact; as desiring at least presentable public disclosures, firms would be forced to improve internal controls. All assessments being widely available will potentially promote competition, thereby improving governance standards on the whole. And most importantly, increased transparency and control will have a positive impact on the share price. Historical and current data support this share price increase argument. The mere announcement of the introduction of Clause 49[3], in May 1999, caused large cap companies’ share prices to increase by c. 10% over a 2-week window.[4] Infosys, the most revered company for its corporate governance, by both CRISIL and CARE[5], gained 1.33% from 7th January 2009 (the day Satyam CEO disclosed the fraud) to 9th January 2009 (the next trading session). In the same time period, Satyam shares lost 50% of their value while the NIFTY Index lost c. 1.62%[6]. In fact even the introduction of SOX in the US in 2002, caused an upward swing in the share price movement. Thus CGA is not just a cost centric exercise alone but can translate into significant tangible gains for an organisation.
With majority control being held by insiders, earnings management is a highly probable event. While not totally illegal, the practice leads to deficient disclosures and ambiguity in financial statements. In order to align interests of the promoters (typically also the senior management of the company) with the wider shareholder base, there needs to be minimal earnings management. To successfully implement this, the audit committee must have on board at least one independent director with financial expertise. Clause 49 requires that the audit committee has one independent director and one financial expert. However, it does not make it mandatory for both characteristics to be represented by the same member. A study conducted by Carcello, Hollingsworth, Klein and Neal in 2006[7] concludes that the inclusion of an independent director on the audit committee with in depth financial knowledge and experience is the most efficient in extenuating earnings management. The study also highlights that this is in particular true for firms with weaker corporate governance standards. Given that most Indian firms are family owned mid sized companied, maybe the Clause 49 requirement should be amended to require an independent financial expert being a member of the audit committee. Additional experts and/or independent directors will only strengthen the team.
It is interesting to note at this point that the Satyam board, which had many a reputable name from the industry as members, could not identify a fraud of this magnitude right under their noses. There are questions surrounding the monitoring of the Satyam audit committee. Here Khanna and Black’s study, Indian Corporate Governance an Overview, provides an interesting input. Apparently less than 70% of the 293 Indian corporates they sampled, have bylaws governing the audit committees. The reality and implementation of these bylaws is further questionable. Clause 49 probably needs to further detail the working of the audit committee and its reporting. A more focussed watch and detailed analysis might cost Indian companies a little extra, as independent directors begin to demand higher remuneration for their time and efforts. However, that will be money well spent and hopefully will lead to improved corporate performance and a more credible shareholder base.
Corporate performance also depends on the investments, fund raisings, capital utilisation resolutions passed by a CFO’s office. These key financial decisions impact the balance sheet of the company; shaping the return on capital. The 2008 derivatives’ scandal in India, which caused multi million dollar losses for the small and mid-cap companies, illustrated how unknowing CFOs took decisions to the detriment of the shareholders. In the absence of knowledge and expertise, an investment made by an individual without the board approval, puts the company’s balance sheet even in greater danger. In numerous cases, the derivatives investments made by SMEs were not approved by the company boards. Thus the board, under Clause 49, probably needs to be empowered to regularise the dealings of the CFO’s office.
Away from the company, one avenue that requires new legislation is that of generally accepted accounting principals. The Institute of Chartered Accountants of India (ICAI) has made proactive efforts in bringing international accounting standards to India; to integrate local policies with the global practices. To this extent, ICAI has even adopted 15 International Accounting Standards (IAS) out of the 33 IAS. However, due to the absence of prescribed statutory obligations, accounting standards in India still remain inadequate and non-uniform; dependent on the interpretation of the company auditor. Take the case of FCCB issuance in the country. While most securities issued will redeem at a premium to the issue price, there is no requirement for companies to account for the accretion of the bonds. This has the potential of creating significant liability mismatch upon maturity of the bonds. In the absence of a market norm, every company follows an accounting standard different from its peers. In some instances, the company follows one standard that has a partial impact on the balance sheet and then ignores another standard only to protect the financial statements from being further impacted.[8] There needs to be a concerted effort by ICAI and the law-makers to limit the alternate interpretation of accounting standards.
Corporate governance is not only about finance and economics. However, since most global corporate governance scandals revolve around these two issues, maybe the capitalistic society needs to address these two aspects before any other pillar supporting corporate governance is touched for refurbishment.
[1] SEBI: Securities and Exchange Board of India
[2] Currently only 50 of the 4,700 listed firms have undertaken the CGA exercise. Of these 50, only 19 have disclosed these assessments. Source: www.livemint.com
[3] Clause 49 of SEBI’s listing agreement
[4] Source: Black, Khanna; Can Corporate Governance Reforms Increase Firms’ Market Value: Evidence from India
[5] Source: www.livemint.com
[6] Source of statistics: www.nse-india.com
[7] Audit Committee Financial Expertise, Competing Corporate Governance Mechanisms, and Earnings Management
[8] A study conducted by Shankariah and Rao, using a sample set of 40 private an public companies, showed that the majority of the sample companies (65%) disclosed using five to ten accounting policies. 22.5% of the sample companies disclosed using more than ten standards. The remaining disclosed using less than 5 standards. 87.5% of the sample public limited companies complied with five to ten accounting standards.
In the particular case of Satyam, an expectation of legal proceedings commencing this early might be premature; however, it is probably high time that corporate governance reforms are implemented in India. Given that Clause 49 of SEBI’s[1] listing agreement already calls for measures akin to the Sarbanes Oxley (SOX) act of the US, is there any further room for regulatory improvement? A brief analysis underscores a few avenues where further amendments, to increase the corporate governance and transparency standards, are possible.
To begin with, independent corporate governance assessment (CGA) and its disclosure should be made mandatory for all listed firms.[2] While this might seem an extreme reaction, it will have an impact; as desiring at least presentable public disclosures, firms would be forced to improve internal controls. All assessments being widely available will potentially promote competition, thereby improving governance standards on the whole. And most importantly, increased transparency and control will have a positive impact on the share price. Historical and current data support this share price increase argument. The mere announcement of the introduction of Clause 49[3], in May 1999, caused large cap companies’ share prices to increase by c. 10% over a 2-week window.[4] Infosys, the most revered company for its corporate governance, by both CRISIL and CARE[5], gained 1.33% from 7th January 2009 (the day Satyam CEO disclosed the fraud) to 9th January 2009 (the next trading session). In the same time period, Satyam shares lost 50% of their value while the NIFTY Index lost c. 1.62%[6]. In fact even the introduction of SOX in the US in 2002, caused an upward swing in the share price movement. Thus CGA is not just a cost centric exercise alone but can translate into significant tangible gains for an organisation.
With majority control being held by insiders, earnings management is a highly probable event. While not totally illegal, the practice leads to deficient disclosures and ambiguity in financial statements. In order to align interests of the promoters (typically also the senior management of the company) with the wider shareholder base, there needs to be minimal earnings management. To successfully implement this, the audit committee must have on board at least one independent director with financial expertise. Clause 49 requires that the audit committee has one independent director and one financial expert. However, it does not make it mandatory for both characteristics to be represented by the same member. A study conducted by Carcello, Hollingsworth, Klein and Neal in 2006[7] concludes that the inclusion of an independent director on the audit committee with in depth financial knowledge and experience is the most efficient in extenuating earnings management. The study also highlights that this is in particular true for firms with weaker corporate governance standards. Given that most Indian firms are family owned mid sized companied, maybe the Clause 49 requirement should be amended to require an independent financial expert being a member of the audit committee. Additional experts and/or independent directors will only strengthen the team.
It is interesting to note at this point that the Satyam board, which had many a reputable name from the industry as members, could not identify a fraud of this magnitude right under their noses. There are questions surrounding the monitoring of the Satyam audit committee. Here Khanna and Black’s study, Indian Corporate Governance an Overview, provides an interesting input. Apparently less than 70% of the 293 Indian corporates they sampled, have bylaws governing the audit committees. The reality and implementation of these bylaws is further questionable. Clause 49 probably needs to further detail the working of the audit committee and its reporting. A more focussed watch and detailed analysis might cost Indian companies a little extra, as independent directors begin to demand higher remuneration for their time and efforts. However, that will be money well spent and hopefully will lead to improved corporate performance and a more credible shareholder base.
Corporate performance also depends on the investments, fund raisings, capital utilisation resolutions passed by a CFO’s office. These key financial decisions impact the balance sheet of the company; shaping the return on capital. The 2008 derivatives’ scandal in India, which caused multi million dollar losses for the small and mid-cap companies, illustrated how unknowing CFOs took decisions to the detriment of the shareholders. In the absence of knowledge and expertise, an investment made by an individual without the board approval, puts the company’s balance sheet even in greater danger. In numerous cases, the derivatives investments made by SMEs were not approved by the company boards. Thus the board, under Clause 49, probably needs to be empowered to regularise the dealings of the CFO’s office.
Away from the company, one avenue that requires new legislation is that of generally accepted accounting principals. The Institute of Chartered Accountants of India (ICAI) has made proactive efforts in bringing international accounting standards to India; to integrate local policies with the global practices. To this extent, ICAI has even adopted 15 International Accounting Standards (IAS) out of the 33 IAS. However, due to the absence of prescribed statutory obligations, accounting standards in India still remain inadequate and non-uniform; dependent on the interpretation of the company auditor. Take the case of FCCB issuance in the country. While most securities issued will redeem at a premium to the issue price, there is no requirement for companies to account for the accretion of the bonds. This has the potential of creating significant liability mismatch upon maturity of the bonds. In the absence of a market norm, every company follows an accounting standard different from its peers. In some instances, the company follows one standard that has a partial impact on the balance sheet and then ignores another standard only to protect the financial statements from being further impacted.[8] There needs to be a concerted effort by ICAI and the law-makers to limit the alternate interpretation of accounting standards.
Corporate governance is not only about finance and economics. However, since most global corporate governance scandals revolve around these two issues, maybe the capitalistic society needs to address these two aspects before any other pillar supporting corporate governance is touched for refurbishment.
[1] SEBI: Securities and Exchange Board of India
[2] Currently only 50 of the 4,700 listed firms have undertaken the CGA exercise. Of these 50, only 19 have disclosed these assessments. Source: www.livemint.com
[3] Clause 49 of SEBI’s listing agreement
[4] Source: Black, Khanna; Can Corporate Governance Reforms Increase Firms’ Market Value: Evidence from India
[5] Source: www.livemint.com
[6] Source of statistics: www.nse-india.com
[7] Audit Committee Financial Expertise, Competing Corporate Governance Mechanisms, and Earnings Management
[8] A study conducted by Shankariah and Rao, using a sample set of 40 private an public companies, showed that the majority of the sample companies (65%) disclosed using five to ten accounting policies. 22.5% of the sample companies disclosed using more than ten standards. The remaining disclosed using less than 5 standards. 87.5% of the sample public limited companies complied with five to ten accounting standards.
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