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Business News/ Opinion / Creative accounting in listed companies
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Creative accounting in listed companies

Independent directors have failed to protect minority shareholders

Illustration: Jayachandran/MintPremium
Illustration: Jayachandran/Mint

The inefficiency of Indian capital markets has troubled regulators for years now. The low participation rate of retail investors in the stock market has been a major cause of worry, pointing to crucial structural problems in the system. Undoubtedly the quality of financial data available to investors is one of them, especially in light of the recent conviction of B. Ramalinga Raju and nine others in the Satyam scam and the crucial role that information on companies’ financial health plays in decisions regarding capital allocation.

It is in this context that a July 2014 report prepared by India Ratings, a credit assessor, gains importance. The report points to the poor quality of financial statements prepared by publicly listed companies in India, with “significant likelihood" that companies even in the top hundred of BSE 500 companies could be involved in creative accounting practices. The figure comes from the study of the financial data of 421 companies over 12 years. Among all, the pharmaceutical, automobile and packaged consumer goods sectors remain most prone to the malice of accounting gimmickry. Under-reporting tax liabilities, depreciation and other costs such as interest, and selling and distribution expenses are some of the techniques used to misreport actual costs; while channel pushing is a favourite tool to create illusory sales that boost revenue.

The urge for companies to meet Street expectations is a crucial factor driving the adoption of creative accounting practices, especially during economic downturns when the pressure on earnings increases considerably.

What is more intriguing about the numbers is the alleged influence of promoters’ shareholding on the quality of companies’ financial statements. The study finds that companies with over 50% shareholding by promoters are more likely to misstate their accounts in order to impress the markets. That illegal management of accounts could take place in collusion with the board of directors, as the report suggests, also brings into question the poor state of corporate governance in India.

In the recent past, the issue of the rights of minority shareholders has focused attention on the importance of independent directors in company boards. Last year, the Securities and Exchange Board of India announced new corporate governance norms which included steps limiting the tenure of independent directors to prevent their collusion with managements at the cost of other minority shareholders.

The debate on granting more powers to independent directors in order to improve corporate governance is indeed an important one. The control that minority shareholders exert over management decisions may be undermined due to management dominance by promoters. In such cases, intervention by independent directors on behalf of minority shareholders may be crucial, apart from shareholder activism which has recently been on the rise or a wholesale exit of investors from the stock.

But the finding that company boards with majority shareholding by promoters are more prone to doctoring their accounts could be a doubtful proposition. In fact, greater promoter interest in companies may reduce the incentive for the controlling promoters to engage in practices that could jeopardize the long-term interests of their company. This may in turn work to the favour of minority shareholders whose interests may be perfectly aligned with those of the promoters.

The emphasis on independent directors is overstated given that it has achieved little success even internationally. Quite famously, legendary investor Warren Buffett in his 2002 letter to shareholders termed the performance of independent directors in the US, where laws mandate half the board to be made up of independent directors, as “absolutely pathetic".

The state of financial reporting indeed points to the poor overall quality of corporate governance in the country. But the solution lies in designing better forms of accountability with greater involvement of shareholders themselves rather than the continued emphasis on appointment of independent directors who have in the past failed to uphold the interests of shareholders.

How can the quality of financial reporting in India be improved? Tell us at views@livemint.com

Follow Mint Opinion on Twitter at https://twitter.com/Mint_Opinion-

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Published: 16 Apr 2015, 04:08 PM IST
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