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Still a distant dream

Corporate reporting in India has miles to go before attaining the transparency levels as found in the US, says R. Srinivasan.

ONE OF the reasons for investor-apathy in recent years could be that corporate promises, more often than not, do not match actual performance and there is also no means of investors keeping track of company performance other than through sketchy, and often dressed-up, quarterly results.

Of late, even good performances, indicated by the quarterly results, have been met with lukewarm responses on the stock market, as investors are not sure whether these results can be sustained over the entire financial year or if there would be a bombshell in the next quarter or by the end of the financial year. True, there have been some improvements of late in reporting, at least among the bigger companies, which have begun commenting on adherence to the principles of good corporate governance. But these are merely periodical secretarial progress reports, more to do with compliance with accepted principles than the future of the company's operations or factors likely to affect the company's operations.

Investors are least concerned about how many times the board met during the past year or the existence of special committees, such as an audit committee; it is understood that these are basic internal controls through which the members of the board, or the corporate governors, elected by them would ensure the proper governance of the company. Most of the corporate activities, including administration, investor-relations, reporting, and so on, have been relics of the past through our association with the British. But one has only to look at the American practices in these areas to be able to appreciate what it takes to win investor-confidence, so important for sustaining corporate growth and, indeed, for maintaining the growth of the country's economy.

The information technology (IT) sector has become the current darling of the investors because of the potential it has shown for capital appreciation even in the short term. It has attracted tremendous investor-interest, both from the disciplined ones and the herd. All sorts of companies have mushroomed in recent years obviously to exploit this craze among gullible investors. This, therefore, calls for strict vigilance from the regulatory authority by enforcing reporting norms.

Investors have thrown all conventional valuation norms, such as the PE multiples, to the winds and the valuations of many of the IT companies have defied all logic as they are based not on current performance but on their potential earnings capacity. This phenomenon, however, is not peculiar to India; it is prevalent in the US too. But the Securities and Exchange Commission (SEC) there has made it mandatory for companies to make a special report in Form 10-K under Section 13 or 15(d) of The Securities Exchange Act, along with their annual reports, for filing with the SEC.

This special report is a sort of compliance report, but deals with such details as the company's organisation, the industry-background, strategy for the future in various areas of its operations, factors that may affect its future results, besides a complete discussion and analysis of financial condition and results of its operations during the financial year.

The report considers specially the use of forward-looking statements of the company's plans, objectives, expectations and intentions accompanied by words such as `plan', `estimate', `expect', `believe', `should', `would', `could', `anticipate', `may' or other words that convey uncertainty of future events or outcomes involving risks and uncertainties.

A look now at the main features of these special reports -- including annual reports -- which are, as yet, unheard of in Indian corporate history. Two companies, both from the IT sector in the US, have been chosen for this study, as this sector is the riskiest especially insofar as the future of the industry is concerned.

PMC-Sierra, a leading manufacturer of high-speed, high-density broadband communications semiconductor architectural solutions, has included a special section in its latest annual report highlighting ``factors that the investor should consider before investing in the company'', as the company is subject to a number of risks -- some normal to the networking semiconductor industry and some which may be present in the future. These risk factors have been clearly stated for investors to assess for themselves the extent to which they can take the risk of investing in the company.

In brief, the factors are as follows:

Risk of a decline in revenues should one or more customers change their ordering pattern;

Risk of a decline in revenues from customers using competitors' products;

Risk of a delay in increasing revenues arising from a redesign of the company's products to meet the rapidly evolving industry standards;

Risk of a decline in earnings owing to a downturn in the networking industry arising from a change in the demand for the customers' products;

Risk of a less-than-anticipated increase in earnings arising from an inaccurate estimate of the customers' needs as product development is done several years ahead of their volume production;

Risk of affecting profitability by acquisition of other companies and technologies;

Risk of profitability being affected by lower margins on mature and high-volume products;

Risk of outsourced supplies of products failing to meet delivery schedules and lack of access to adequate capacity or certain process technologies;

Risk of sub-assemblers in Asia failing to meet schedules of shipments;

Risk of impairment of sales, development or manufacture of the company's products arising from conducting business outside the US;

Risk of decline in profitability from significant fluctuations in foreign exchange rates;

Risk of difficulty in collecting receivables from customers based in foreign countries;

Risk of dilution in earnings per share as a result of: issue of securities for funding the company's operations, the exercise of employee stock options, or issues during any acquisition process;

Risk of market non-acceptance of new products; and

Risk of changes in the company's product prices and those of its competitors.

PMC-Sierra has also included in its annual report a glossary of a number of terms used in the report, stating that while these terms are familiar to industry participants, some of the investors may not recognise these.

This aspect only highlights the extent to which the company has gone in making the report and its implications easily understandable even for the lay investor.

The special report annexed to the annual report of i2 Technologies Inc. (filed with the SEC) states, among others, that the liquidity of the company could be affected significantly from provisions for doubtful accounts besides slowdowns in the realisation of accounts receivables which could fluctuate for a variety of reasons, such as the amount and the timing of revenues earned, the company's collection experience, the terms of payment negotiated, longer payment terms for receivables generated from international customers as compared to customers in the US and the number of large sales for which some amounts may not be due upon execution of the contract.

The report highlights, under the head ``Management's discussion'', items that have a significant effect on the company's profitability, especially on types of revenues earned and expenditure incurred in the specific areas of software licences and services. Expenditure incurred in software licences

constitute a very important component for the company, as it is incurred mainly to increase customer awareness of the potential benefits derived from deploying the company's software solutions. Such expenditure is incurred in order to generate sales through sales alliances, distributors, resellers and other indirect channels. Cost of software licences usually consisted of commission paid to third parties in connection with joint marketing and other related agreements, royalty fees associated with third-party sales, the cost of user documentation and the cost of reproduction and delivery of the software.

Services constitute a major activity for the company as they represent expenditure incurred on consulting organisation as a result of the increased demand for the company's solutions and, also, from the use of third-party consultants. The report explains that service revenues as a percentage of total revenues have fluctuated, and are expected to continue to fluctuate, on a period-to-period basis based upon the demand for implementation, training and consulting services.

The report is candid in its treatment of software development costs. Under the US Financial Accounting Standards, software development costs are expenses as incurred until technological feasibility has been established, at which time such costs are capitalised until the product is available for general release to customers. For the company, the establishment of technological feasibility of its products and general release of such software had coincided substantially and no part of the software development costs had, therefore, qualified for capitalisation. This is specially noteworthy as the management perception in a majority of cases, especially in environments such as ours, would be to increase the profits by capitalisation of these development costs.

For the Indian investor -- for long fed on sketchy, lacklustre reports on past performance (not to speak of future expectations) dictated by the patriarch chairman or the home office (as most of the businesses hitherto were owned by family groups or MNC affiliates) -- there is not much room for cheer. Unless the shareholder-base widens by a dispersal of holdings, there will be no worthwhile transparency of reporting nor any meaningful participation in the companies' affairs.

The mutual funds with their volume of operations and holdings in companies are in a position to insist on their compliance with reporting on the lines of the US companies and this also requires the active involvement by the regulatory authority.

For the foreseeable future, therefore, investors in India, especially the retail and the small, will have to rest content with developments in the rest of the world and leaving equity market operations in the hands of operators based, not on financial fundamentals or future prospects, but largely on speculative instincts.