S&P ESG INDIA INDEX-the success of socially responsible investing

The above graph says it all. After a 15month hiccup from its Jan-08 launch(where it performed same as other indices), it broke away in Apr-09, and has not looked back since. A nearly 2.5yr track record of out-performance is not a joke. Now, one may argue that it was lucky to exclude under-performing sectors like PSU banks etc, but still that speaks for the strength of the selection process. Surprisingly, Shariah indices underperformed their broader counterparts despite excluding the poorly performing financial services sector.

The methodology document claims that  "It is an index based purely on quantitative factors rather than subjective ones.  For the first time, environmental, social and corporate governing factors have been extensively quantified and translated into a series of scores measuring securities in the universe of publicly traded Indian companies.  This index not only ensures a selection of environmentally, socially and corporate governance responsible companies, but also securities which are representative of the Indian equity markets based on size and liquidity"

The measures certainly seem exhaustive but on closer scrutiny do not stand up to sustained scrutiny. For instance, the data sought in the initial template for corporate governance is largely boilerplate. The few distinguishing factors are remuneration, rationale for independent directors etc. But otherwise, do they really expect companies to disclose details on corruption/business ethics? And if they do, are they rewarding companies who hire PR agencies like Trisys to publish glossy annual reports with plenty of irrelevant disclosures, but with little information otherwise? But, the data sought for the environment/social conduct does seem more differentiating, because very few companies have disclosed these things in the reports I've seen. Things like anti trust, quality, product safety and pollution hardly exists in the lexicon of companies. And they disclose stuff like labour relations etc because that is mandatory in the annual report.

There is potential to to improve the factors by adding stuff like independent directors, special resolutions passed, audit qualifications, sustainability report publishing etc. But then, that would become too subjective. And then,150 companies with the highest scores under the initial process are selected for the qualitative process, whose score(1-5) is summed with initial core to yield final result. So while some unworthy candidates may clear the initial round, they are unlikely to pass the qualitative round.

Conclusion-While all the quantitative scoring factors are part of mandatory disclosures/not totally relevant for ESG investing, they seem to work. So like the late Chairman Deng, I shall not bother about the colour of the ESG index, as long as it continues to outperform. Do investors in Indian equities really care, or are the factors correlated with superior performance? Or is it survivor-ship bias? I leave these questions for you to ponder on, the factors used in the methodology, are copied below

Template for Assessing Conduct on Governance of Indian Companies
Ownership Structure and Shareholder Rights •  Shareholder Capital •  Shareholder Rights
Financial and Operational Information •  Financial Information •  Operational Information
Board and Management Structure and Process •  Board and Management Information
•  Board and Management Remuneration
Business Ethics and Corporate Responsibility •  Corporate Governance •  Corruption
•  Leadership •  Business Ethics
Template for Assessing Environment and Social Conduct (E& S) of Indian Companies
Environment •  Environmental Pollution •  Natural Resources Use
Management Policy and Performance Indicators Employees •  Employee Relations/Job Creation 
•  Labor Rights •  Equal Opportunity  •  Union Relations
Community •  Human Rights •  Community Investment
Customers/Product •  Product Safety •  Anti-trust •  Customer Outreach and Product Quality

How Government policies play havoc with share prices-sugar, coal, steel..

Recently, UP announced a hike(yet again!) in the prices sugar mills need to pay farmers for their cane. This, without any improvement in yield. Unsurprisingly, the states moved court, and demanded a stay on the order. But irrespective of the legal gymnastics, the market already responded and hammered down sugar stocks, sending premier players like Shree Renuka Sugars to their 52 week lows.

But this story is not only for sugar. When the draft Land Acquisition Bill was promulgated mandating compensating existing project affected people to the tune of 25% of profits, the coal sector took a major hit especially PSUs like Coal India, because unlike the private sector, they do not have the option of challenging the act in court. Another factor which played havoc under the previous Environmental Minister Jairam Ramesh, was the delaying/banning mining in certain areas. While that hit even other companies, Coal India again took a major hit. And while one may argue that the policy stayed same-only the law of the land was enforced-one cannot deny that this was a political shock.

And when the export tax on domestic iron ore was increased, the steel lobby salivated at the prospects of cheaper steel. But when the Karnataka mining scam forced the Supreme Court to react, it switched to the other extreme and stopped mining in all but 2 mines, and ordered open auction disregarding the existing supply contracts. Hence, companies like JSW Steel without their own captive mines, suffered the most and saw lower capacity utilization. Of course, the Govt policy of not challenging the SC order, played a role in this, but again it was in no position to do so.

Takeaway: When the inputs/outputs are strongly regulated by the state, there is a case to embedd this discount into the stock, because one does not know what will happen next in this political environment.

How the Indian Government/Regulators are creatively using checklists

Auditors have known the importance of checklists for long. Indeed, the audit programs are nothing but formalized and modified time tested checklists. But while auditors are trained to avoid the checklist 'tickbox mentality' and to 'think beyond the checklist', the same has not yet penetrated the compliance mindset. There are a plethora of laws/regulations/rules which need checklists. A few are listed below

• Corporate governance compliance checklist to be filed by listed companies with the stock exchange under Clause 49 of the listing agreement
• CARO 2003 checklist to be attached to the audit report, under the Companies Act 1956
• Due diligence checklist to be filled by the merchant banker and mentioned in prospectus
• Compliance calendar and checklists used for routine compliance purpose
• Due diligence checklists used during M&A, to ensure that no liability is missed out
• Pre-filing validation for e-forms/tax returns/TDS returns to ensure that the mandatory requirements are satisfied, and that wrong data/inappropriate numbers are not filed. This is indirectly using the same checklist manifesto. .

 However, all these checklists are dstatutorily mandated. There is tremondous scope for using checklists even for non routine work, to ensure that nothing is missed out. While this may implictly be done during audit planning, it would not hurt to have an output checklist to service as a work guide AND a milestone reference. As Atul Gawande's seminal book 'The Checklist Manifesto' apttly puts it, even highly skilled professionals may commit mistakes unknowingly out of habit, unless they internalize a checklist and bother to update it often. In case of CAs, professional judgement instances such as client acceptance, audit qualification, degree of audit evidence/sampling etc are all cases where a checklist would be very useful to ensure internal consistency. Other innovative ways to use checklists are

• Tickoff legal agreement clauses against desirable elements, to check for contract completeness and unusual terms. For example, an outlicensing agreement without audit rights, IPR reversion at end of term etc, is unusual to say the least, and may signal legal risk later on. This is done when approving VGF requests. This practice should be more widely followed.
• Using cross checks in tax returns check/PDS eligibility determination etc.

When it pays to disclose-examples from investing and valuation

Some examples are given below from business and beyond.

• The more prior art is cited in patents, the more valuable they become. That is because the patent itself works around the existing pathways instead of using them. Therefore, it is not only novel but often preempts expensive infringement suits. 
• The more broad the claims, the less difficult is it to bypass patents. That is why patent offices globally are very careful to avoid granting(or revoke if already granted) broad patents-as the infamous example of the infringement suit which Henry Ford had won. 
• In M&A deals, the agreement often states that material adverse change shall not include any risk factors already outlined in the publicly available financial filings(eg 10-K risk factors). 
• Narayan Murthy of Infosys recalls that when Infosys lost money in share market speculation during its initial years, it came clean to the investors and promised not to be so careless next time onwards. Investors readily forgave them, because of them being upfront. 
• During public offerings, if the regulator deems that disclosures in prospectus are insufficient, then the issuer/promoters are liable to suits from investors who want compensation for post issue share price crashes
• A standard analyst tool is to check for the quality and quantity of disclosures, to cut the financial risk from investor angle. So companies who disclose more are rewarded.

How the CA profession changed circa 2011-a lookback in 2020

We cannot (yet) travel in time, so only time can test my predictions of how the CA profession will evolve. However, so many exciting changes are happening(we live in interesting times) that I just had to pen down my thoughts to connect the dots, and do some crystal ball gazing

The global subprime crisis gave a boost to principles based accounting and auditing standards(IFRS, audit standards) which were nearly universally adopted/adapted from 2008-2013. But if investors thought it would result in lesser fraud incidence, they were sadly mistaken. The IFRS transition and IFRS induced volatility, led to a comedy of errors, misunderstandings and reratings of stocks/sectors. Management subject to tighter performance linked pay, clawback etc(copied from the Western banking sector pay clampdowns) responded by gaming the metrics. And IFRS was an unwitting accomplice. Realizing that they could use aggressive accounting without earning qualified audit reports, management went all out to polish their books. And the auditors still coming to terms with IFRS, auditing standards, new formats laws etc were always one step behind.  But investors were not dummies. The savvier ones among them(FIIs, PE funds etc) demanded forensic audit to be mandatorily performed in addition.  Companies on their part, realized that investor relations was too important to be entrusted to the CFO/CS, and instead decided to develop their in house teams with business understanding/insight AND with expertise in accounting, marketing and communications.  CAs again were picked up for this role, given their integrated understanding.

The global outcry against income disparities, basic necessity deprivation, corporate ‘huge earnings’, Govt spending , corruption and crony capitalism manifested itself in the Arab spring riots(Egypt, Libya, Tunisia..), Lokpal bill struggle in India, Dodd Frank/Obamacare in USA. The Indian Govt did not set up a Lokpal but agreed to be enhance the e-governance substantially, and introduce worldclass measures like self assessment, uniform tax rates, less complexity, tight but fair penalties, deemed resolution in favour of citizen in case of delay etc. This transparency increased the willingness to pay tax, and increased the taxpayer base to 25% of the population. Of course, this was aided by more withholding taxes(TDS/TCS), transaction taxes(STT, GST) and innovative tax base(MAT, dividend tax, reverse charge etc). After plenty of struggles, GST was introduced in 2015, with dual rates

CAs saw the need to collaborate within the profession(alliances, CPE circles, benevolent fund, networking) and with other professions(LLPs).  The MCA introduction of LLP was leveraged by ICAI to permit these partnerships. And how they prospered! Engineers, architects and lawyers helped immensely in valuation, due diligence and expert opinions in audits; while company secretaries and management accountants lent their name to compliance services, cost audits and transactional services performed by LLPs. Of course, the jack of all trades(CA) remained the managing partner. Stung by the fact that LLPs of mostly other professionals were grabbing the premier cost audits, ICWAI tried to amend its bill to prevent that, but failed due to opposition from other professionals.  Networks of LLPs rose(many of them borne from ICAI networking efforts) and challenged the Big4 in specialist areas like forensic accounting, valuation, merchant banking etc.

The ICAI efforts to increase the quality of entrants in the CA profession worked well. Despite a midway oversupply(May-11 CA Final placements!), the overall consensus in 2020 was that academic toppers entering the field, had done excellently and could challenge their science peers. This reflected in the MBA entrance results where more CAs got into the premier IIMs(instead of having to wait and go abroad/to ISB), as their analytical caliber helped them to crack CAT. Of course, the CA Final exam pattern was made more practical/applied to ensure that bookworms/crammers would not get rewarded for just knowing the contents of a Rs 500 CD ROM! Recognizing that the quality and quantity of CAs was going up, industry recognized this by shifting a good chunk of Tier I and Tier II MBA college placements to the ICAI campus placements.

This would not have been possible without an improved training. Discarding the old system of relying wholly on the employer for training inputs during the 3yr period, ICAI adapted the ICAEW system of learning diaries, to be maintained and uploaded online. Like how peer review/FRRB brought out the best/worst practices for assurance practices, the review of these diaries was a valuable source of course correction for ICAI, to help those students where learning seemed too skewed. And by setting up its own coaching infrastructure(attending those to be counted as articleship!) and centres of excellence, ICAI was able to conduct many more student seminars/conferences/training programs. The communication skills training program was made on par with top MBA programs, and the Information systems course also was so interesting that CAs decided to compete with BTech system auditors!

CAs finally entered the digital age with XBRL, which made data crunching less labour intensive. While some KPOs were not happy(!), software companies embraced the movement to offer 100% automated XBRL solutions, which could then be verified by the CA.  Even the source data(ERP system) become standardized with cloudcomputing based ERP solutions, that allowed even SMEs to enjoy the benefits of ERP without the capex costs and learning costs(project failure etc). These twin developments made it more imperative for CAs to be tech savvy, capable of writing that XBRL coder on the fly if necessary, or to liason between operational staff and software persons.

The general improvement in personnel, systems, tax compliance mood etc made the Govt/Regulators even more trusting, and sparked off a virtuous cycle. Human interface kept reducing(or replaced by helpdesks instead of that pesky inspector!), with the limited manpower focused on major cases/test cases only instead of picking on the small fry. Of course, the severe penalties for fraud/major mistake ensured that the tax payers/regulated parties themselves preferred the least human errors, for which systems were designed to auto generate the returns from the ERP/other MIS. This led to reduction in Finance Dept size(now one did not need so many people to manually prepare the basic stuff!).  Compliance hassles became fewer(thanks to model laws like LLP/new companies Act) as Govt focused on ensuring companies had processes in place, instead of just an accurate output. The CARO question on internal audit sufficiency and appropriateness, expanded to cover a chunk of other key processes like tax.

With all that technology push, finance departments decided to proactively respond to the double dip recession/cost push inflation/high interest rates etc. Management accounting became in vogue again, and companies began to actually read and apply their cost audit reports.  ICWAs finally got their due respect and status on par with CMAs abroad, as companies realized that they had ignored their low hanging fruits for decades. The worst hit sectors(banking, insurance, infrastructure) learnt to apply those lessons, and were now on the rescue path. 

So finally, the profession(service and practice) saw substantial changes. Those who went with the wind prospered, others were left wondering what happened.  

Why 100% audit testing is again in vogue

In the old days of hand made goods, the brand was enough to show that the craftsman had tested the good and certified its quality. As the scale of operations grew, the producers decided to retain the quality marks, but resorted to sampling(around which a whole cottage industry grew of sampling statistics, testings, Six Sigma etc). When the scope of financial audit enlarged from balance sheet audit to include transactional testing, test of controls etc; auditors just lifted the ready made library of tools/techniques from the sampling industry, under the mapping that transactions/records were like goods-for which 100% testing was not economically feasible. While that hypothesis is shrinking in physical goods with the advent of non destructive testing(like acoustic testing, use of optics etc), digitization has made it possible to apply CAATs and digital auditing to do 100% testing of information.

Technological feasibility is one reason, but the real reason is the increasing competition+globalization, which has really reduced profit margins. Companies must now innovate(to maintain the high margins/market share), or else die. The lower profit margins lead to lower audit materiality levels, and therefore need for more audit testing. After all, commodity players operating at 1% margins, would have low audit materiality levels. But even high margin financial sector players have other issues like lax controls, fraud risk, compliance testing etc. Money laundering legislations demand data mining to detect connected transactions. The stray transaction which slipped through, may result in headlines about XYZ bank being a terrorist conduit. To protect their reputational capital, those subject to money laundering legislation must have digital records. And when the underlying digital records are in place, it is a natural leap to use them for statutory financial audit purpose.

Another reason is the increasing frauds/collapse of listed companies, where the public/regulators blame the auditors for being asleep at the wheel. While this perception is due to expectation gap, the audit firms would naturally like to improve the audit quality to avoid such issues. And one of the cheapest(given their economies of scale across clients) ways to do so is to use computers effectively for 100% audit testing.

As I blogged earlier, the data analysis trend today is to use the automated bulldozer instead of the manual shovel. Hence, the need for smart work

Cooking the books-the case of Air India MOU

It is a hallowed tradition in the private sector to 'cook the books', whether it be maintaining multiple books for financial, tax and regulatory accounting; fudging proforma metrics etc. In the Union Civil Performance Audit 2011-12 on NACIL, the C&AG lambasted the Govt-AI MOU, stating that the performance evaluation metrics were not designed aptly.
 The Memorandum of Understanding (MoUs) signed between the erstwhile IAL and AIL and MoCA were flawed. The non-financial parameters included in the MoU included minor or insignificant parameters or gave undue weightage to such parameters, at the cost of critical traffic and operating parameters in the airline industry (such as those being monitored by Directorate General of Civil Aviation). This skewed the MoU ratings of IAL and AIL unduly to present a “rosy” picture of performance. The overall combination of financial and non-financial parameters devised for the MoUs were such as to ensure that the MoUs became a meaningless exercise, rarely (if ever) reflecting poor performance, and ensuring lack of effective accountability for all parties concerned

While this would not meet the strict legal definition of accounting fraud, it resembles the infamous metrics used by Groupon in its IPO prospectus, which had a similar purpose for showing a rosy picture.

The takeaway from this sordid episode is that while reading the Result Framework Document(RFD) uploaded by each ministry on the site, try to exercise your judgement in whether it focusses on critical outcomes, or merely tries to dress up the performance. This will need some technical knowledge and extra effort, but if media attention on AI MOU like cases prevents another AI, it would be worth it