Every detail of that flight to Hyderabad is still clearly etched in my mind.

It was a hot summer’s day in 2008 and having recently migrated to India from the UK, I was flying from Mumbai to meet the CFO one of the leading power and construction companies in India. With me was our power sector expert.

Throughout that 90-minute flight he and I tried in vain to make sense of that power company’s balance sheet – a balance sheet, which contained a high quantum of “loans” in, both, assets and liabilities. Loans taken by this company amounted to as much as its shareholders’ equity. Even more interestingly, money lent by the power company amounted to 1.8x its shareholders’ equity. Why was a power company lending so much money? Who was it lending that money to?

Three hours later in Hyderabad I got the answer after questioning the CFO intensively. The money was being lent to various shell companies. Those shell companies then took equity stakes in the power plants that the power company had won tenders for. Each of these power plants was in a special purpose vehicle, which then gave the “construction” order to the listed entity.

Thus the loans advanced by the listing entity were also being accounted for in the listed entity’s P&L as revenues and hence profits.

These profits obviously boosted the listed entity’s shareholders’ equity which allowed it to borrow more money from the banks and that in turn allowed it to finance more power plants (for which the construction order would come to the listed entity).

It took me another week or so to understand the full extent of this accounting shenanigan but once I realised how widespread this practice was I decided in the autumn of 2008 to make forensic accounting a key specialism of the stock broking teams that I managed.

Our analytical skills are in such high demand that we regularly have to turn down requests from large Indian and foreign banks to help them identify fraudulent corporate borrowers.

Most investment committees in Indian and foreign asset management firms now make it compulsory for investee companies to be subject to rigorous accounting analysis. As a result, we find that the correlation between accounting quality and investment returns is gradually tightening.

Our statistical analysis shows that within most sectors in the Indian market, accounting quality alone is responsible for 30-50 per cent of the share price movement shown by stocks. Corporate India too is changing in response to this heightened awareness of accounting quality. Whilst I still get a nasty call or two from Indian corporates who don’t like being put under the scanner, many corporates have used the FY11-13 downturn to clean up their act by writing down non-existent assets and imaginary revenues.

Although this superficially heightens the impact of the ongoing economic downturn, the gradual move to more conservative accounting practices is a big long-term plus for the Indian market.

In contrast to some of the East Asian stock markets such as China – where forensic accounting still hasn’t found strong roots – Indian companies’ accounts are arguably cleaner now. In this, as in other spheres of life, evolution, rather than revolution, works to India’s benefit.

The author is Head of Equities, Institutional Equities, Ambit Capital. The views are personal.

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