- April 8, 2020
- Posted by: Shivani Chopra, CFA
- Category:BLOG, Events
Speaker: Sunil Singhania, CFA, Founder of Abakkus Asset Management, LLP
Contributed By : Srividhya Venkatesan, CFA
Session Notes of webinar- “CIO’s Insights: Detecting Financial Irregularities”
What is Financial Irregularity/ Window Dressing?
To express it simply, the golden rule is: When the left hand side of the Balance Sheet has nothing right and the right hand side of the Balance Sheet has nothing left.
In recent times, there have been several cases of massive financial irregularities by Indian Companies on their Balance Sheets including Satyam Computer Systems, Educomp, Tulip Telecom, Geodesic Systems to name a few. There have been large global companies as well, which have engaged in such manipulation and financial irregularities like Valeant Pharma.
Similarly there have been many cases of companies which have faced liquidity issues like Manpasand Beverages, Kwality, Mcleod, Eveready and several NBFCs. Such cases could have been identified as potential liquidity case much earlier had these companies been evaluated in-depth, purely from financial perspective.
Its key to remember that the Penalty of not identifying such irregularity can be massive.
Top 20 losers as of June 11, 2019 (over a period of 1 year)
As can be seen from the chart, the top 20 losers lost 78-93% of their market cap in a matter of 1 year period (till June 11, 2019). Most of them were not small companies, and some had market cap of INR 10,000-15,000 Cr. In most cases the losses were not because of their business loss but mainly due to some kind of financial irregularity.
Top 20 losers as of June 11, 2019 (over a period of 2 years)
Similarly, in case of the Top 20 losers over two years time period (till June 11, 2019), the loss ranged from 89-97% of their market value. Cumulatively these companies had a value erosion of around INR 2 Lakh crores (approx $30 billion) in market cap over two years. Again, most lost because of financial irregularity.
What could be the motive?
The motive could be three edged: (a) pressure or incentive, (b) rationalization and(c) opportunity
Pressure or Incentive: Lot of these actions relating to over reporting are because of pressure,greed or underlying incentive in the form of ESOPs. When there are large options, there is a clear cut marrying of purpose between over reporting and benefits. When large options of the key management is involved, one should be a little bit more careful while checking the financial statements.
Rationalizing: Market likes consistency. Pressure of consistency often leads to rationalizing of results. Sometimes management may decide to rationalise a bad quarter and making adjustment in the next good quarter to make the books back in order. But when there is a series of bad quarters, a big bubble of misreporting could happen which is difficult to correct in future quarters.
Opportunity: Senior management have the opportunity, power, access and authority to manipulate accounts.
Typical financial irregularity
Overstating earnings, overstating financial position, overstating operating cash flows, corporate governance/auditor issues/related party transactions, preference to owners v/s others, related party transactions, using reserves to smooth out profitability: are the most common irregularities that eventually lead to misuse of reserves and provisions
- Overstate Earnings
|Irregularity||Typical Red Flags|
|· Aggressive revenue recognition
e.g. revenue based on orders rather than actual deliveries or treating inventory as sale which is reversed in subsequent years
|· Compare revenue recognition policy relative to peers
· Check if receivable is growing faster than the revenues
· Are margins much higher than peers
· Is operating cash flow significantly lower than accounting earnings
· Revenue occuring in last quarter
|· Deferral of expenses – spreading of expense over multiple years||· Capitalisation of expenses (e.g. software, patents etc)
· Jump in Intangible Assets
· Unexplained increase in assets such as inventory relative to revenue
· Depreciation policy lower than followed in the sector or vis-à-vis peers
|· Classifying one time income/non-operating income as recurring income||· Whether source is being disclosed properly
· Whether one-time/non-recurring income has been included in revenue
· Whether revenue pertains to revaluation of assets
|· Classifying operating expense as one-off expense||· Read explanation provided in notes to accounts
· Are there unusually higher margins relative to peers
Management quality and credibility is more important than business itself, specially for smaller companies where the history is new or those which are not being tracked by research analysts.
Several qualitative aspects should also be checked, while evaluating a Company:
- Management history, qualification and track record – how management behaves during headwinds. The true test of character is only during challenging times.
- Succession readiness and capability
- Diversification of board– whether truly independent
- Capital allocation – should be ROE accretive
- Purposeful mistakes or business errors
- Any other business outside listed company
- Holding structure, personal leverage etc
- Key audit matters
- Politically sensitive business/promoters
- Capital distribution – whether done fairly to minority shareholders
Case Study 1: Impact of Over-stating Earnings
- While sales zoomed between 2009-2015, a major part of the revenue was not translating to cash and was rather getting parked as inventory and debtors. A clear case of over-reporting sales and resultant profits
- Due to this continued over-reporting, the cash flow from operations in March 2016, reached negative INR 1,482 Crores
- And to manage the balance sheet – debt increased substantially
- It was a clear case of embezzlement of money
(b) Overstating Financial Position
- Taking liabilities off the book in form of Non-Fund based liabilities. Non fund based liabilities in form of Letter of Credit, Bank Guarantee, which become fund based liabilities when default happens. Similar scenario was witnessed in Geetanjali Gems
- Building large intangible assets
- Using other non-consolidated entities to hold assets and liabilities
- Lease equipments instead of buying equipments to keep liability off the balance sheet
- These mis-reportings could artificially improve key financial ratios like debt-equity ratio, return on assets
The best way to detect this irregularity is to read the Notes to Accounts in-depth and focus on intangibles (specially in IT and Pharma sectors). Acquisition should also be evaluated in detail to see if actually a Goodwill has been created. Though in-depth analysis becomes very difficult when it is an outbound acquisition.
Case Study 2: Impact of over-stating financial position
- Sales grew 20x between 2006-2013 and PAT also grew. As sales rose, the debtors and debt also rose substantially
- The intent was clearly to overstate profits, to get more debt. Which was parked in form of debtors
- At one point the debt became very high and the company went bust
(c) Overstating Operating Cash Flows
- Expenditure improperly classified as capital expenditure
- Borrowing transactions treated as operating cash inflows
- Accelerating cash received from revenues or deferral of cash paid for expenses
- Often in such cases of irregularity, the Balance sheet would reflect high cash balances but with minimal Other Income (like in case of Satyam Computer)
(d) Misuse of Reserves and Provisions:
- Showing cash received in advance as revenue
- Unbilled revenue (common in construction and IT company)improperly recorded in books
(e) Corporate Governance/Related Party Transactions/Auditor issues:
- Management not acting in the best interest of shareholders
- Insufficient representation on board
- Management use of excessive compensation, perks or inappropriate expenditures
- Related party transactions at inflated price
- Change of auditors
Some other warning signs:
- Miscellaneous expenditure as % of revenue
- Current Asset turnover v/s new capex projections
- Provision for doubtful debt as % of gross debtors
- Contingent liability as % of of net worth
- Delay in filing of audited accounts
- Lower tax paid v/s. regular tax rate reflected in tax provisions
- Change in key accounting policies
- High customer concentration
- Extraordinary High Profit/ EBITDA margins
- Complicated group structure
To sum up, we professionals must be conscious of these financial irregularities while reading financial statements and should look out for warning signs to avoid loosing money.
Link to complete webinar- https://www.cfainstitute.org/en/research/multimedia/2019/cio-s-insights-detecting-financial-irregularities