The Hindu : Towards better corporate governance

Online edition of India's National Newspaper
Thursday, May 29, 2003

Opinion

Opinion - Leader Page Articles

Towards better corporate governance

By N. Vittal

The accounting could include all the notional values and the underlying assumptions clearly spelt out so that the investor is well protected.

THE DRAMATIC collapse of Enron and shenanigans of multinationals such as Worldcom have focussed attention on how accounting norms can be juggled to project a totally misleading picture before the investors in the capital market.

This type of accounting sleight-of-hand and window dressing seems to be a phenomenon present even in that bastion of capitalism, the United States. In the U.S., the immediate reaction was to pass the Sarbanes Oxley Act, which ultimately fixed the responsibilities on the Chief Executives. Some of them have also been jailed for misleading the public through "creative accounting".

In India also the issue of corporate governance has been taken up and the SEBI and the Naresh Chandra Committee have tried to bring some semblance of transparency to the accounting systems. The Generally Accepted Accounting Practice (GAAP) basically centred in the U.S. was taken as the guiding principle in many countries.

Nevertheless, in India also the shock of the collapse of multinationals like Enron have raised doubts whether even following the GAAP would ensure the accounts reflect the correct reality about the financial health of an enterprise.

It is no wonder that in this context corporate governance has become a widely discussed issue. Attempts are being made to ensure that the companies adopt good corporate governance practices. Corporate governance involves three elements. The first is transparency about the affairs of the company and the decision-making process.

Without transparency there will be no accountability, which is the second element in corporate governance. Accountability for decisions and actions taken will be possible only if the system is transparent.

And finally we come to the third element, Accountability for what or to whom. Accountability is to the stakeholder in the business enterprise. There will be different types of stakeholders.

The most common and perhaps the most vital in the accounting context are the shareholders, who are the investors. Other stakeholders are consumers, suppliers, and employees of the organisation as well as society at large reflected in terms of the environmental impact of the enterprise.

Every report on the state of accounts and financial health of an enterprise has two aspects. One can be called the hard aspect. This includes the actual cash inflow and outflow.

The other can be called the soft aspect. This includes all items of notional value, which is of vital interest to the investment analyst. These notional values are the soft aspects of accounting and include items such as good will, accounting for the tax-deferred debts and liabilities and so on.

It is in the area of soft accounting of these notional values that there is tremendous scope for mischief. For example, one of the tainted companies in the U.S. was able to show what was really an expenditure as income. One of the pending issues evading a general solution is the accounting for the employees' stock option.

Where do we go from here? Is there a way for resolving the problem of proper accounting so that investors in the capital market get an accurate picture of the financial health of a company? I would suggest a solution which may appear simplistic but is basically sound. I would suggest that the reporting of the accounts of an enterprise must be in two parts.

The first part must be restricted to the actual cash transactions, which can be verified by anyone. This is the hard aspect of accounting. This will provide a reality check about the financial health of the company for any prospective investor. The entire tribe of analysts and financial experts as well as large enterprises in the business of investment management do not have to disappear overnight.

The second part of the accounting could include all the notional values and the underlying assumptions clearly spelt out so that the investor is well protected. If he takes a risk in investing in the enterprise, he knows it from the beginning.

Oscar Wilde said that the thief is an artist and the policeman is only a critic. It is still possible for crooks to play with the figures especially in the area of notional values to give a totally misleading picture and take the people for a ride.

How can we forget, for example, the hundreds of the vanishing companies which flourished in the 1990s? These companies came with an initial public offering, collected funds and disappeared into thin air. It is possible still for crooks to adopt such strategies.

As the Americans say, a sucker is born every minute. In this two-part accounting system at least the investors can be sure that they have hard data to make well-informed decisions.

This hard-soft distinction has been applied in realpolitik also. I saw an analysis where the efforts made by France and Germany to stall the U.S. attack on Iraq as an exercise in using the soft power of diplomacy to combat the hard power of military strength and economic strength, which America represents.

When it comes to the financial status of an enterprise we can perhaps distinguish between the hard accounts aspect of the actual flow of cash and the soft aspect of notional values.

If we make this distinction possible, perhaps, we would have taken a step towards a healthier and more honest way of reporting the financial health of enterprises. This may in the process lead to a better system of capital markets.

In the area of notional values there is a need also for another step to be taken to protect the investor. This is the U.S. concept of the "law of the blue skies".

In the United States, the courts recognise that new forms of fraud may arise which may not covered technically under any existing law and cannot be interpreted as violating any of the existing laws. For example, a clever conman can try to sell a piece of the blue sky. In order to check such crooks, there is the concept of the blue-sky law.

We may also, in India, adopt the concept to further protect investors who in spite of the hard aspect of accounting in terms of cash flows may be hypnotised by smart conmen into parting with their cash in dubious investments.

(The writer is a former Chief Vigilance Commissioner.)

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