Indian Debt Market... Really?

CA YOGESH GUPTA

(Sr. Associate Analyst – ICRA Limited)

Dear Optimist, Pessimist and Realist. While you guys were arguing about the glass of water, I drank it.     

                                                                                                                            -Opportunist

Funny, isn’t it? While the Law Makers, Judiciary and we, the people, were busy arguing about the pathetic state of law and order in the country the banks seem to have sighted the opportunity in adversity and made a killing. Read on…

India has a very sophisticated and well-developed equity market -- comparable with the best in the world; however, the debt markets (Debt market refers to the financial market where investors buy and sell debt securities, mostly in the form of bonds) in India remain underdeveloped.  In fact, the secondary debt market in India is practically non-existent.

Reasons for Failure

Why has the debt market failed to develop in India?

Debt markets deal with fixed income securities that offer defined payoffs to investors over a defined time period. The risks inherent in debt markets are of two kinds -- credit risk or default risk and interest rate risk or duration risk.

Interest rate risk arises from changes in the opportunity cost of capital among various market participants between the time a fixed income security is issued and the time it is completely paid off. This is a risk that originates in the hands of the holder of the security (for the most part). If a country has an efficiently functioning market system, where trades are settled and where the clearing system ensures protection from default by individual market participants, this risk is handled well by the marketplace.

We do have a well-functioning government bond and securities market, primarily because it carries no credit risk and only carries interest rate risk (The Indian government routinely runs budget deficits of 3% to 5% and the shortfall is met through borrowing in the domestic government securities market). But, the corporate debt market (even for the highest rated corporates) has failed to take off. The reason the market has failed to take off has very little to do with the availability of capital or the existence of securities and market instruments. It has more to do with the feeble legal system in India and non-existence of strong bankruptcy, insolvency and receivership laws messed up further with sloppy implementation.

The corporate debt market deals with credit risk in addition to interest rate risk and it is in the case of the former that India is found wanting. What is the remedy?

Scenario in the U.S.

In a developed market like the U.S., if a company is unable to meet its debt obligations, it has to file for bankruptcy where all the equity is written down and where the residual assets are either liquidated or reorganized and allocated to different claims (societal, employee, crown and private debts) in their order of seniority. Although the process can be laborious, lengthy and prone to high accounting and legal fees, it works and follows the rule of law.

This is not the case in a market like India which is victim to orchestrated defaults/restructuring by corporates.

FCCB Shining!

During the 2006-07 frenzy, an interesting market called the foreign currency convertible bond (FCCB) market developed for Indian companies. These were bonds issued in foreign currency by Indian companies and sold offshore with embedded options for conversion to equity at predetermined premiums. In the go-go bull market of the time, investors lapped them up. For issuing companies, the benefit of lower interest rates on current debt with the potential conversion at a premium to equity at a future date seemed too good to let -go. FCCBs worth billions of dollars were issued by several Indian companies and absorbed by foreign investors.

As we know, the story got very interesting with the financial market collapse of 2008-2009. The financial market collapse of 2008-09 brought an unfortunate twist to the story and to the fate of the investors.


Stock values plummeted deep out of the money (in reference to the convertible option prices on the FCCBs) and the prices of the bonds themselves lost more than half their value.

Of course, crisis followed

During all of 2009, investors in the FCCB market remained in a state of panic. They eagerly negotiated settlements with issuing companies and many of the bonds were redeemed by companies (or bought back) at 50 to 60 cents on the dollar.

The problem is that Indian law and Indian courts do not accord sufficient sanctity to a private debt held by a private (non-bank) entity. The laws in India are enforced to almost exclusively protect the interest of banks that lend to private entities secured against collateral. In fact, until the securitization of collateral (SARFESI – Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest) act was passed in 2002, even a bank had to struggle through years of litigation before being able to enforce foreclosure on collateral offered against a defaulted loan. With the enactment of SARFESI, lenders secured by collateral (limited only to banks and recognized domestic financial institutions) could enforce their security interest on a defaulted loan without going through the judicial system.

How does the existence of a vibrant debt market benefit the U.S. economy and how does it harm the Indian economy? The entire Indian economy is dominated by the commercial banking system. The banking industry is dominated by government-owned banks (for a change!), which although very well run, are effective oligopolies. India is one of the few places left in the world where banks are able to earn net interest spreads of 3% to 4% on their loan books and are extremely profitable in their plain vanilla ‘deposit accepting - loan making’ business.

Taking a Toll

This has a huge toll on Indian companies (borrowers) and significantly reduces the efficiency of the economy along with high levels of systemic risk. With the exception of the 50 largest corporations in India that are large enough to be rated externally and borrow in foreign currency internationally, all Indian companies are dependent on the banking system for their debt financing requirements.

While Debt markets in India suffer from chronic neglect on the part of policy makers, despite the fact that there is clear evidence of fairly strong debt preference among households for their financial investment portfolio, the U.S. debt markets allocate capital very effectively and creditworthy borrowers are able to raise debt resources on very competitive terms. Even non-creditworthy and high-risk borrowers are able to raise resources (albeit at high cost) to enable them to undertake their high risk ventures (some of which eventually turn out to be among Fortune 500).

The developed and deep financial markets are therefore a vital asset to the U.S. economy. Unless the government in India is able to put in place the structural changes required to its legal and regulatory systems and ensure their effective implementation, its debt (and hence capital) markets will remain underdeveloped, placing its corporations at a disadvantage to those dwelling in economies with developed capital markets.


(All views expressed above does not belong to the Pro Edge 111 team, & are solely the opinion of the author)

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AUDIT PROFESSION- GLORY LOST?

-Nupur Goel

There has been a spate of incidents of late, both in India and abroad, which have raised serious doubts over the integrity of auditors and have put their role in the dock. Be it the Enron-Arthur Andersen scam or the closer home Satyam-PW fiasco, the goodwill and faith that auditors enjoyed for decades has surely been tarnished. More skeletons continue to tumble out, as in the much publicised case of over-valuation of a leading Andhra Pradesh based Publication Company, where the accounting firm admitted to have succumbed to the pressure of a politically influential client. Or a few days back, U.K. based regulating authority slapped a fine of $ 2.2 mn on a leading audit firm for failing to report irregularities. The cases are innumerable, and the bottom line is: “Faith” the founding stone of the profession has been shaken.

Let us first take a look at the major issues that confront the audit fraternity and the factors which have made them so vulnerable. The primary ethos on which the faith of the users of audit report is founded are: Auditor independence, professional scepticism and judgement.

Auditor independence of late has become a very contentious issue. An auditor is not only required to appear independent but he should also be independent ‘in fact’. Being independent in appearance requires the auditors to avoid any circumstances which can raise doubts over their professional objectivity. Being ‘independent in fact’ refers to the state of mind of the auditor. That is, he/she should have an objective approach towards his work and not get influenced in any manner. However, the quintessential ‘independence’ is largely diminished because of several factors such as familiarity, intimidation, self-interest etc. It has been seen in several cases that the audit association of major audit firms with their clients lasts as long as two to three decades! This brings to the fore, the need to have a healthy rotation of audit firms.

Professional objectivity is often the victim in the tussle between professional ethics and self- interest. Most audit firms render additional non-audit services to their audit clients. This not only deepens the association between the auditor and the client, but also leads to an increased dependence on the client for revenues. The instinct for preserving one’s interests often takes precedence over professional responsibility. The audit world also sees seething rivalry among various firms. For the sake of client appeasement and retention, the rules are often bent.

All this has deeply dented the goodwill and reputation that the profession has enjoyed for so long. It has also been the subject of a lot of debates, all of them reverberating the need to usher in major reforms. In order to re-engineer the structure of major accounting firms especially the multinational audit firms, which have been embroiled in many a corporate scandals of late. Reforms are also required to revamp the system of audits by bringing in legislative changes.

Scenario in the West:

The Public Company Accounting Oversight Board (PCAOB)  in the US and the European Commission in Europe have proposed to move some major reforms in the profession in response to the massive scandals and the issues identified during the global economic meltdown.

These reforms are aimed at clarifying auditor’s role, promoting their independence and to induce more competition into the concentrated audit market. Some major changes they seek to introduce are:

·         No client to exceed 15% of the annual revenue of the firm.

·         Prohibition on rendering non-audit services to audit clients.

·         Requiring large firms to hive off their non-audit capabilities.

·         Mandatory rotation of auditors every 6 years(9 years in case of joint audits)

·         Mandatory tendering for appointment of auditor- a transparent and open audit procedure involving audit committee.

·         Revising audit report to include aspects like length of audit tenure, extent of balance sheet verification, details of materiality, identity of each member of audit team.

Many of these are important legislations which shall greatly reform the face of the profession. However, some proposals such as requirement to hive off non-audit wings, details of each audit member etc. seem biased and show lack of foresight on the part of law makers.

Scenario in India

India too, is in the eye of the storm and has been jolted by scams and audit irregularities. Lawmakers have attempted to address and check these issues by amending the Companies’ Bill, which contains the powers and duties of auditors and other aspects of corporate governance.

The proposed Companies Bill has mandated the rotation of auditors and audit firms by introducing the following provisions:

·         Any prescribed company shall not appoint

o   Any auditor for not more than one term of five years.

o   Or an audit firm as auditor for more than two terms of five consecutive years

o   An auditor who has completed his term of five years shall not be eligible for re appointment for another term of five years.

o   An audit firm which has completed its term as stated above shall not be eligible for re appointment as auditor in the company for five years from the completion of such term.

•          Clause 143 of the bill proposes to make Auditing Standards mandatory in nature. This will ensure improvement in reporting and provide a better framework for carrying out audit functions.
•          If an auditor, in the course of the performance of his duties, has reason to believe that an offence involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the Central Government. This is a path breaking legislation because earlier there was no onus on the auditors to report to the Central Government directly about any fraud. Thus, audit shall no longer be a post-mortem. Rather it shall serve as a mechanism to ensure that the company’s health and governance is sound.
•          Clause 144 of the said bill proposes to impose a prohibition on rendering of certain non-audit   services by the auditors to their clients. Some of them are: accounting and book keeping, internal audit, investment advisory, actuarial, management services etc.
•          The bill proposes to reconstitute The National Advisory Committee on Accounting Standards-NACAS; as introduced by the Companies Bill 2009 to National Financial Reporting Authority (NFRA). The objective of NFRA shall be:

                      i.            make recommendations to the Central Government on the formulation and laying down of accounting and auditing policies and standards for adoption by companies or class of companies or their auditors

                    ii.            monitor and enforce the compliance with accounting and auditing standards recommended by it in such manner as may be prescribed

                  iii.            oversee the quality of service of the professions associated with ensuring compliance with such standards, and suggest measures required for improvement in quality of services and such other related matters

                  iv.            And to perform any other prescribed functions.

   ·         Clause 138 seeks to provide that it shall be mandatory for prescribed companies to conduct internal audit of their functions and activities, by appointing a CA or CWA and in the manner as prescribed by the Central Government.

   ·      Clause 447 proposes penalty for auditors, in case the audit firm or partners of audit firm act in a fraudulent manner.

The bill, when passed by the parliament, shall bring about a major change in the way the audit world operates. It also seems to be targeted at breaking the dominance of the multinational audit firms and to bring about more competition in the audit market. Matters like rotation of auditors, restrictions on rendering non-audit services have evoked mixed response from eminent Chartered Accountants and members of India Inc. In this regard, it would be important to quote CA P.R. Ramesh, chairman, Deloitte India, who made a noteworthy remark on the proposed legislation, in an interview:

When asked about how the mandatory rotation would impact the profession, he said:

 “Profile of a profession should mirror the environment it serves.”

“They are the same horses and you are saying rotate within the horses. So you are not necessarily going to find new horses” (Horse has been used as metaphor for auditors).

By this he suggests that that the rotational aspect won’t serve the intended goal if audit professionals across the spectrum have the same approach towards their work. As the incoming auditor would not have anything better to offer than the incumbent.

 On being asked how the Big Four will be impacted by the legislation he said:

“If you take top 500 companies the Big Four will not have a share exceeding 50%. So point I am driving home is that when you are introducing rotation you have very few firms of size or geographical presence. The rotation will happen only within the few. So if you are trying to correct the profile of the profession by introducing rotation it’s not going to happen. On the contrary if 50% are not audited by the Big Four it is more likely that they will move to the Big Four.”

Members of India Inc. have also expressed their concerns over how effective the proposal of mandatory rotation shall be in ensuring auditor independence. Also some fear that it may give rise to a situation wherein major firms have a ‘mutual’ swap of their audit clients amongst themselves, once they vacate office upon retirement. The law if implemented shall only bring in a “perception of independence”. However, the spirit of law would be defeated.

The law envisages to make it mandatory to appoint independent internal auditors for all companies of a certain size. Such internal auditors would be appointed by the shareholders on the recommendation of the audit committee and would be rotated every three years. This would be particularly beneficial, as it would make internal audit more effective and independent. Also the requirement to report serious frauds to the government directly and setting up of a Serious Fraud Investigation Office would ensure speedy detection and redressal of issues.

However, the need of the hour is ‘self-regulation’ on the part of the professionals to bring about a paradigm shift. Measures like legislative regulations, over regulation by the parent body, peer review etc. will only bring about limited results.  The tide will really change only when the professionals themselves decide to dawn the mantle and adhere to them in word and in spirit.

Although the last decade has been marred by incidents and scandals, however, this cannot undermine the good work auditors have done for so long, with undeterred aplomb. With stringent regulations and self-correction on the part of the professionals, I am hopeful that the past glory shall be restored to the profession.

In this regard, I would quote a line of the famous poet Percy Bysshe Shelley:

“If winter comes, can spring be far behind.”

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Ind AS 2: Inventories

-Pranav Pareek

Dear Friends,

Here is a presentation on Ind AS 2: Inventories (Converged with IFRS).

In this PPT, we have covered almost each & every aspect of this standard. Apart from detailed study of this Ind AS, this PPT also contains quick links to jump to various specific topics & a comparative study between Ind AS 2 & AS 2. Hope you find it useful.

Click Here (To download, go to file menu and save)

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