How to Smell a Rat? An Introduction to Financial Shenanigans

Contributed by: Ashok M , CFA

Saurabh Mukherjea, CFA enthralled the audience with his presentation on Forensic Accounting, at the IAIP event in Bangalore, held on 03^rd August, 2017.

How many of us knew that misreporting or fictitious accounting can be found even among companies that are part of the Nifty Index? This put the audience on notice! Among BSE 500 index constituents he put the comparable number at 150.

Ambit has studied and catalogued companies according to its accounting quality. Investment return chases accounting quality. Their study shows that over a 5 year period, the top decile companies in terms of accounting quality outperform the bottom decile companies by 10% on an average.

Good quality stocks outperform bad quality stocks in the long run. Barring exceptional periods, good quality stocks perform well even in the short term. It is a myth that traders make money in the short term at the expense of long term investors. The opposite is true.

The best analogy that most of us understand well is Cricket. Saurabh brought out a little known trivia relating to the scores of the ‘Wall’ Rahul Dravid, and the ‘Legend’ Virendra Sehwag. In the longer version of the game, Dravid averages 55, while his counterpart’s is at 49. In the shortest form the game as well, the ‘Wall’ outperforms the ‘Legend’! While Saurabh didn’t give out detailed statistics, I did go back and check. To my pleasant surprise both in ODIs and T20s the averages are in favour of the more consistent Rahul Dravid. This is one analogy that many wouldn’t forget for a long time.

However, markets can be unfair to serious investors. Investor’s who sift through tons of annual reports and market research can sometimes see their efforts go unrewarded for particular durations in the market. The last 12 months in one such time period. The bottom decile, low quality, ‘rubbish’ stocks have run up quite a bit.

How does one detect fraudulent accounting? Few of the drivers for misreporting are

• Hiding the damage caused by pursuing unviable mergers and acquisitions
• Exaggerating Revenues
• Theft by Promoters
• Extortion by powerful third parties.

Saurabh briefly touched upon the macro environment in the context of accounting. He persuaded us to see the disconnect between economic realities, such as low plant load factors, falling occupancies in luxury hotels and juxtaposed this with the exuberance in the financial markets.

The speaker again drilled down in the audience minds that some of the largest companies (part of the Nifty index), have patently false balance sheets. Some of the management commentaries, in the eyes of the seasoned analyst, are worthy of laughter. Some of the balance sheets are so asset-heavy that they hesitate to write-down unworthy assets. A write-down would trigger loan default and the company would collapse like a house of cards. To keep the charade going, the management would weave new stories and figures in its annual reports each year.

The Nifty complex is crowded with companies that derive mileage by its proximity to the government. About 70% of Nifty companies operate in traditional sectors which are monopolised by the government in terms of licenses and access. For instance, companies in power, infrastructure or financial services. It is an indication that these companies are under great pressure to manipulate the presentation of facts and figures.

As a test experiment, one can look at the quarterly results in the run up to a QIP or IPOs. Revenues and profits would be boosted. Once the IPO/QIPs materialised, the result in the following quarters would fall precipitously – as the unwinding of inflated figures takes place.

Another illuminating finding is that IPOs have barely made money for Indian investors. Yet, the frenzy around IPOs hardly abate. As per Ambit research, barely 15% of IPOs, makes inflation adjusted return. Nevertheless, the public chases IPOs with a frenzy that is unwarranted.

How do you spot cooking the books?

There are four approaches to spot cooking of books

• Profit and Loss Misstatement
• Balance Sheet Misstatements
• Pilferage of cash
• Audit quality checks

CFO/EBITDA is a helpful ratio to detect overstatement of profit figure in the P&L statement. A unitary result is ideal. Less than unitary points to profit overstatement.

Provision for doubtful debts / Debtors greater than 6 months is another ratio to test overstatement of Sales and overstatement of current assets. The speaker showed real examples of companies which have very low provision rates but carry a disproportionate amount of debtors greater than 6 months.

Sometimes it is possible to game cashflows as well. The company could move cash to the balance sheet from a related entity closer to year end. To detect this, a clever test could be to calculate cash yield percentage. If the yields are lesser than money market rates, then quite likely cash has come into the balance sheet towards the close of the year.

Entries directly made into ‘Changes in Equity/Reserves’  instead of routing through the Profit and Loss Statement need to scrutinized. Saurabh cited the example of a prominent FMCG company that amortised the intangible value of the brands that it acquired directly in the ‘Changes in Reserves’ statement instead of the Profit and Loss Account.

To guard against gaming of CFO, by routing certain outflow transactions through CFI, one could look combining CFO and CFI and dividing the same by Revenue to check free cash flow accrual.

A healthy discussion took place on the topic of auditor remuneration. Saurabh showed some of the metrics that one could use to detect compromise in audit quality or collusion between auditor and management. He asked us to keep an eye on audit remuneration increase compared to sales, audit fee as a percentage of revenues. However, care should be taken to compare companies of like industry and like quality.

To check antecedents of directors on Board a useful site is watchoutinvestors.com

What are some of the Red flags that one usually comes across

• Unusual volatility in depreciation
• Low proportion of independent directors
• Intermittent spike in travelling and business promotion expenses

Saurabh showed us a real life case of a wrong classification of Capital Reserves and Securities Premium Accounts in the capital structure of a company in one year and how the rectification took place a year later with a concomitant increase in auditor fees!

Suggested Books for reading:

Terry Smith: Accounting for Growth

Howard Schmidt: Financial Shenanigans

To an audience question of an instance of good accounting practise, Saurabh referred to Tata UK’s pension accounting methods following UK GAAP as a fine example of transparent accounting. But such practise is not pervasive across the group. Tata Motors, for instance, capitalises its R&D expenses, which is not the practise with other global auto motive majors.

Again, the myth to be busted is that small companies are infested with fraudulent accounting while the larger counterparts have pristine reporting practises.

In final, Saurabh referred to the cyclicality and predictability of irrational exuberances, the scandals, the pains that investors go through. Yet, lessons learn are little and the process repeats itself. He referred to the low yield in the Commercial Paper market (about 6%) because of excess funds to be loaned out. The rating agencies have liberally assigned highest rating to 90% of the issues. The Bond funds have been receiving healthy inflows as investors shift savings from bank deposits and other non financial savings to financial savings.

The discussion concluded with some reference to regulatory frictions such as the ban on short-sale and restriction on security lending by mutual funds, and lack of institutional strength in other parts of the market (such as auditor supervision, rating agency remuneration issue). Some of which, if corrected can go a long way in improving the integrity of capital markets.

-AM