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Sunday, August 21, 2011

Want to sharpen your audit awareness/knowledge? Read these free documents

It is said that the 'best things in life are free'. A counter to that is that 'easy come easy go' and that 'free things have no value'. While the truth lies somewhere in between these two extremes, one should note that RTI and public disclosure norms often ensure that Govt organizations disclose very useful information at times. This is mostly lost in the morass of trivial data, till somebody uncovers them. Below are some examples

  1. CAG:- Their entire site is a gem(reports, guidelines etc) but their directions issued under Section 619(3) of the Companies Act 1956, are very informative, wherein they extend the audit scope. I've not seen some of these points even in the best checklists. Read those directions here(http://cagofindia.delhi.nic.in/caempanel/directions_2010.htm)
  2. FCI:- These days, the Food Corporation of India is more in the headlines for rotting foodgrains than for anything commendable. Still, by posting the circular of its stock taking directions(http://fciweb.nic.in//upload/circulars/APV%20Instructions.pdf) along with the stock sheet proforma(http://fciweb.nic.in//upload/circulars/APV%20FORMATS.pdf), it provides a very educative source of information for students and agriculture sector accountants. 
  3. CCI:- The Competition Commission of India may have goofed up in its order penalizing NSE for 'predatory pricing'(though it may have spurred NSE to start charging from the month post the order), but its sector reports are quite useful and incisive. Often, media/management sees things through rose tinted glasses and 'professional skeptism' is lost, but reading the CCI reports ensures that one is well grounded in reality. For instance, this report(http://www.cci.gov.in/images/media/completed/transport_20090723115524.pdf)  on competition in Railways/Ports was written in 2009 but is still quite valid and insightful-it speaks equally of the quality of research and lethargic pace of reforms. Read their other reports and orders too. 

Depreciation Reserve Fund-it can happen only at Indian Railways!

Those well versed with even basic accounting, may remember that famous edict that depreciation is not a reserve but a provision, also that it is not a source of funds, but a non cash expense. But,

While commenting on the deplorable finances of the Indian Railways, the CAG remarked in its report(http://saiindia.gov.in/english/home/Our_Products/Audit_Report/Government_Wise/union_audit/recent_reports/union_compliance/2010_2011/Railways/Report_No_33/exe-sum.pdf) that for the period 2009-10, Indian Railways reduces its appropriations to the depreciation reserve fund by Rs 2313 crore, and that CAG was worried about the impact on safety/renewal of capex.

To understand this oddity,one must appreciate its structure. It is a departmental undertaking of the Railway Ministry, and prides itself on giving a fat dividend cheque to the Finance Ministry. Hence, any cash operating surplus(after 'appropriating' depreciation) would largely be paid out as dividend. The reason depreciation is an appropriation is because railways still follows cash system of accounting, where depreciation does not figure. Hence, a seperate entry is passed for that, which in fact understates the operating ratio.

Friday, August 19, 2011

How auditors try to detect financial reporting fraud-and why they often fail

Post the Satyam scam, where even cash balances were found to be non existent, investors/analysts may be forgiven for thinking that auditors are watchdogs who bark after the horse has bolten from the stable. However, this is not for want of intellect, ability, training or even professional norms. An entire professional standard SA-240 covers this topic(read this here This standard has several interesting aspects for both students and investors/analysts.

  1. Financial audit being post facto, it relies on evidence, often 'triangulating' it by seeking consistent evidence from multiple sources. However, collusion between management and third parties(bank officials, warehouse keepers etc) may cause the auditor to believe that audit evidence is persuasive when it is, in fact, false. For example, non existent customers may confirm debts! 
  2. With the advent of principles based accounting rules(IFRS/Indian GAAP), it is difficult for the auditor
    to determine whether misstatements in judgment areas such as accounting estimates are caused by fraud or error. At best, the auditor can insist on the company tabulating a sensitivity analysis to show range of P&L outcomes, but this may easily be overlooked. And remember that the auditor cannot second guess management judgement, even if it is at the aggressive end of a valid/possible range. 
  3. Like most other professional standards(even other professions like valuers do this), tone at the top is assumed, that management will create a culture of honesty and ethical behavior. Investors are not babes in the wood, and often know which companies(even those in Nifty/Sensex) are not having that tone at the top. When that is the case, the investors should know that they are knowingly bearing greater fraud risk, and should not protest too much on fraud being discovered. 
  4. While management has discretion to select and apply accounting policies(compliant with AS), auditor shall, to check for earnings management efforts, evaluate whether that choice is indicative of fraudulent reporting. Some examples(personal, not in SA 240) are including cost of land for measuring percentage completion, overuse of 'strategic investment rationale' to defer impairment charges, using gross method over net method etc. As these examples show, that risk is more for transactions involving subjective measurements and complex transactions.
  5. Good professionals will accept clients only when convinced of their integrity. This may make them unsuspecting.To prevent bias, SA 240 mandates professional skeptism,  despite the auditor's belief  that management and those charged with governance are honest and have integrity
  6. Fraudsters should be fooled by randomness! So an element of unpredictability in the selection of the
    nature, timing and extent of audit procedures is desired.

While an auditors have an unique(less than only promoters/management) access to the books/records/operations, fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Auditors are capable of uncovering the fraud, but like other professionals must operate within the scope of their mandate. Fraud check would need expensive forensic accounting/investigative skills, which not all companies can afford. While law mandates having an internal audit system appropriate to the size/set up of the company, this cannot avert management fraud-where management itself overrides the system.

Assessing legal risk-an investor guide

Open any annual report, and chances are that you would see a plethora of legal risks(here, legal merely means a violation of any contract/law, which is under dispute). An IIM-A Prof famously said 'law changes at the stroke of the pen'. That pen stroke can cost billion-just ask Vodafone, SKS Microfinance, Reliance Communiations, RNRL, Reliance Industries, HCC, JSW Steel etc-all victims of recent legal related issues.They may be
  1. Tax related-that table you see attached to the audit report, listing the forum/subject matter/tax amount and period of the dispute. This may be related to direct or indirect taxes. While the company/its legal expert would ordinarily have evaluated the chances of winning before deciding to litigate, remember that companies starved  of cash flow may have little option, but to contest perfectly valid tax claims. While Vodafone TDS dispute hogged the headlines, there are many other disputes below the surface such as service tax on real estate, license fee for telecom, TDS issues for telcos/airlines etc
  2.  Litigation related:- Companies typically wriggle out of disclosures when they are on the losing side by claiming the protection of 'sub judice' disputes. Still, where amounts at stake are signifc
  3. Proposed legislation/Draft Reports:- It is sad that most investors/analysts may not bother to read the detailed draft/bill, but prefer to rely on the press release/some summary out there. Whether it be the Lokayukta reportwhere Sesa Goa crashed till it released clarifications), AP MFI Bill/Central MFI Bill(which lead to SKS microfinance stock see-sawing), mining bill(where mining stocks fell); market did overreact before sanity prevailed. For the recent bills(on ports, land acquisition) etc, this knee jerk reaction has decreased, maybe because noone expects these bills to be passed during the current log jam of Parliament. 
  4. C&AG Reports:- Thanks to an activist C&AG, and a media hungry for that next soundbyte/breaking news, C&AG reports are the next source of fear for companies. Even a mighty giant like Reliance lost 10% due to a C&AG accusation of goldplating. Given this, what hope do others have? This, although actual legal action and enforcement would take years, due to which NPV would be lesser
  5. Political:- The Mayawati Govt threw hurdles into RPower's projects in UP, thanks to his links with her rivals the SP. Mamta Bannerjee's Govt's first act was to confiscate the Singur properties of Tata Motors, which she perceived as siding with the Left.  When the DMK fell out of favour with the UPA at the centre, the AIDMK state Govt leapt on Sun TV like a hungry vulture. To keep Sharad Pawar's NCP toeing the party line at the state level, HCC's premier project Lavasa(where his shadow ownership is whispered about) was held up for months on environment grounds,  till court intervention. As infrastructure analysts would concur, projects(especially irrigation, roads) are doled out as rewards for electoral support-though the PPP framework is reducing this. 
  6. Raids by income tax/labour inspectors/receipt of notices:- Satyam is fighting a case where the IT Dept has demanded thousands of crores of additional liability on (as per Satyam) non existent income. This would impact the valuation till the matter is resolved. People with legal flair can analyze and benefit. Also, at times, there are news announcement of 'search and seizures','surveys','raids' etc. One should note that unless the company is formally charge sheeted/arrests made/fines recovered, this news is as good as noise. 
Moral:- One can crystal out certain lessons from these sorry tales
  1. Avoid a knee jerk reaction, and read the full bill/draft/details, and assess the probability of loss. This would need more than passing legal knowledge, so using an expert may help for important issues
  2. Assess political leanings of corporates, as change of governments(more common in this coalition era) may turn corporate fortunes topsy turvy
  3. Where a landmark tax verdict has been rendered, chances are that the next Budget will contain an amendment to reverse that favourable(to taxpayer) verdict with retrospective effect. This has happened for the offshore oils services income tax, cigarettes excise duty, lottery tickets service tax, realty service tax etc; and is likely to happen again. So hesitate before factoring in tax wins in the valuations.

Thursday, August 18, 2011

Idea Cellular's non standard industry metrics-genius or facade?

As a quite profitable operator, Idea Cellular exemplifies the best in the Aditya Birla group-disciplined expansion targeting growth without sacrificing profits. And with their famous ad campaigns(tree, Abhishek Bacchan), quality & market share, the stock market is now paying special attention to Idea. To even maintain profits at 2007 levels seems a dream for most telcos, but Airtel and Idea have managed it quite well.

Obviously, Idea broke quite a few rules to get where they are today. But to openly disclaim industry standard metrics(as their new MD did in the FY11 concall) is surprising. He reiterated that in the 1Q'12 call stating that In the last earning call I had mentioned Idea as a company, had upgraded its competitive  ability by challenging the standard telecom market review parameters like subscriber count, ARPU and ARR. We instead, have focused on five critical internal parameters namely absolute gross revenue, cash profit and EBITDA, active subscribers, total minutes of use and mobile number portability.

Below is an analysis of these parameters, and comparing them against the ones they replaced
  1. absolute gross revenue:- This metric was supposed to replace ARPU(scaled up). It does focus the attention on volume as opposed to pro rate metric, but can't see the difference really
  2. Cash profit;-Telcos use FCF, but Idea seems to prefer cash profit. Again, little difference
  3. EBITDA :- This is one measure used by all and sundry to dress up profits, and Idea is no exception.
  4. Active subscribers:- Here, Idea does a good thing of ignoring idle subscribers, and focussing on actual users. But here, definitions are key. Reliance considers even 1 use/months as 'active use', whereas Idea's definition is unknown to me. 
  5. Total minutes of use:- Again, this seems inferior to metrics like 'Paid Minutes of Use' as RCOM uses. And then, AGR/Total Minutes of use=ARPU. Why trash a metric whose numerator AND denominator you are anyway using
  6. MNP:- Erosion/Addition of net subscribers is a good measure of competitive standing and quality perception, and Idea does well to focus on this metric.But then, so does every one else.
I see just one genuine new metric-active subscribers-which other players do not play up. This is certainly not throwing out the old metrics. 

Monday, August 15, 2011

Paying commission on adjusted operating net profits-L&T sets an example

L&T is one of India's best managed and governed companies. The remuneration was on the lower side compared to competition, but now they decided, as part of their 2015 strategic plan to revise top management remuneration. Now, the companies act allows commission to be paid on basis of net profit-not adjusted for exceptional gains. If at all companies have adjusted this, it has been to exclude impairments etc. But now, L&T has set an example. In its FY11 AGM, it has requested shareholders to approve managerial commission on the net profits after tax of the Company and excluding extraordinary/exceptional profits or losses arising out of sale of business/assets/sale of shares in subsidiary/associates/SPVs/JVs/, and also from sale of strategic investments/adjustments in value of strategic investments. 

A cynic could argue that till the point of sale, impairment of strategic investments are excluded from the profit computation. But then, one must admire the beauty of this scheme. It does not reward 'inorganic' profits, like say how a Jack Welch could have earned from just splitting the entity/financial engineering. And given L&Ts plan of divesting its subsidiaries/stake sales, this little spotted loopholes could have earned millions for the managerial staff.

HDFC(the FI not the bank) the LCC of banking

HDFC Bank has the employer branding of low paying but with a solid work ethic. This philosophy seems inherited from its parent HDFC Ltd, India's premier housing finance corporation, which has now diversified into insurance, student loan lending etc. Consider these facts
  1. As mentioned in the FY11 AGM speech, to print a 152 page annual report(http://www.hdfc.com/pdf/Annual_Report_2010_11.pdf) costs HDFC just Rs 26.16/copy, which seems quite frugal to me. 
  2. Cost to Income ratio hovers around 8%(this year is was 7.7%), among the lowest in Asia. This however, is because only 16% of its loans are directly originated(which need branch/employee costs etc). The remaining loans are through DSAs/affiliates/HDFC Bank, which bear their own overheads. The brokerage which HDFC pays them(partly towards organization costs) are not included in this Cost to Income ratio, but are set off against interest income. Still, considering that HDFC does all the credit appraisal, monitoring and followup itself, this ratio is quite commendable. 
This cost focus is perhaps why HDFC can afford a 43% dividend payout ratio.

While there is an explanation for the low cost/income ratio, I cannot imagine why a reputed printer like Infomedia18 would charge so low for the annual report. Professionals in the IR dept of companies, please comment on this number whether it is on par or lower than normal!

Saturday, August 13, 2011

Selectively picking court orders to inflate profits-some examples

Indian litigation is final only when it reaches the apex court, and is either turned down or dismissed. But till that stage, people can interpret judgements to their convenience, or the assessment whether it will be upheld or dismissed at further courts. Unless the judgement is perverse(evidently wrong on facts/law), it would be apt to pass accounting entries at status quo. But companies often pass entries as per their favoured outcome, thus boosting profits/non cash assets. Below are some examples.

  1. Music royalties from FM radio stations to composers/lyricists:- Indian Performing Right Society (IPRS)  collected royalties on behalf of music composers and lyricists.  But between June-July 2011, the Delhi & Mumbai High courts held that the collection had no legal basis. Both HCs stayed the judgement till September 30, to permit IPRS to appeal for a stay in the Supreme Court. That means the judgement has no legal effect till that date, and may not continue if the Supreme Court agrees with IPRS and grants a stay. Naturally, FM radio channels who had paid the royalties till date were pleased. One of them, Reliance Broadcast Network promptly obtained a legal opinion and decided not only to avoid paying future dues, but also claim refund of the Rs 8.79 crores paid till date. They credited that amount to the accounts, assuming that they would get back those proceeds.  That is indeed jumping the gun, and premature, because even if IPRS loses in the SC, it would be difficult to recover payments made under a mistake of law. 
  2. State Advisory Prices(SAP) for sugar procurement in UP:- An annual charade is played out where the UP Govt fixes SAP much above the Centrally advised MSP(minimum support price). Sugar mills do not want to pay that SAP, and thus approach the HC for stays, which is granted if the mills pay farmers at the SAP pending resolution of the case. Cash outflows happen at higher level, but sugar mills account it at the lower MSP, assuming they would win the case, which is doubtful.
  3. Stayed cess/state taxes:- States periodically impose water cess, electricity duty etc which the user industries naturally dislike. They then waste 3-4yrs at the HC/SC level and end up paying the cess with interest, but till then avoid booking those expenses in their books. Of late, to sanctify this practice, an industry association is roped in to file the suit, so that companies can claim to be following an industry practice. 
Takeaway:- As an investor, be aware of such legal risk, especially if the amounts at stake are high. An example of RNRL should warn even the casual investor, how legal risk can destroy the economics of a company. Even if orders do not destroy the company, adverse outcomes may still erode the share price, with no advance warning(orders usually are not leaked in India!). 

Financial Management examples from Indian annual reports

I'm doing a project involving analysis of corporate reporting practices, so that involves poring through plenty of annual reports, investor presentations and conference call transcripts. At times, it feels like digging for a needle in a haystack, but when you strike gold, it feels good! Below are some examples
  1. Contribution per unit of limiting factor:- When resources are scarce, one goes for the project which maximizes contribution per unit of limited factor(like power, raw material, labour etc). In FY 2010-11, the merchant power prices fell, so  the net payback per unit of power  from Chloro-Vinyl products was better  than  from  sale of power, and thus DCM Shriram increased  production  of  Chloro-Vinyl
  2. Marginal Costing:- Typically, one assumes that since overheads have been fully absorbed, producing to above normal capacity will result in more contribution margins. But when DCM Shriram produced fertilizer over and above their normal/assessed capacity. The additional production was at very low margin as it was on high cost, spot price gas,for which no long term PPA/gas allocation had been done.
  3. Working Capital linkage to business models:-Subcontractors typically have less bargaining power and must operate with positive working capital to finance their main contractors! As Voltas explains in its Mar-11 outlook, the change in business profile has resulted in their being sub-contractor to the turn-key-main-contractors. This results in a longer chain for submission of bills and claims and
    their approval as also the flow of money
    . This has resulted in the receivable cycle getting
    elongated, and therefore, higher working capital.  
  4. Contract costing and measurement:- Companies in infrastructure sector book revenues and profits using percentage completion method, and partly basis their estimated gross profit ratio. In FY2010-11, Voltas noticed for their subsidiary Rohini Industrial Electricals, that contrary to the trend of final margins exceeding estimates used in accounting, there was a negative difference. Hence, it had to reverse some previously booked profits, because the estimated input costs went up etc. This would not have been found out without a good MIS. 
  5. Measuring Customer Profitability/Valuing intangibles:- Intangibles testing under AS-28 mandates that companies should check atleast annually whether the goodwill(overpayment during M&A) they paid for is still worth it or not. Even if economic conditions are stable, strategic changes etc may prompt writing it down. For example, HCL Technologies had this note During the quarter and year ended June 30, 2011 the Company tested all intangibles, keeping in mind its strategy for
    investment and focus on few service lines which will drive future growth. It also evaluated  certain customer related intangibles
    which were being amortized over their useful life. The evaluation was also done with reference to specific customers acquired through acquisition by re-estimating the cost of capital, revenues, profits and the likely period of relationship. Accordingly the Company recorded a onetime impairment charge of Rs. 119.3 Crores. 
  6. Data consistency for decision making:- Often, management accounting, R&D and impairment testing operate from different data points, even in an ERP environment. That is why Glenmark's policy for R&D project management ensures this as its policy(in FY201-11 AR) is to require a detailed forecast of sales or cost savings expected to be generated by the intangible asset. The forecast is incorporated into the Group’s overall budget forecast as the capitalisation of development costs commences. This ensures that managerial accounting, impairment testing procedures and accounting for internally-generated intangible assets are based on the same data.
  7. Standard Costing of inventory in seasonal business:- In a seasonal industry like tea, the overheads incurred in non plucking season will not reflect the realistic standard costs. That is why the world's largest tea producing company Mcleod Russel explains its inventory costing policy as follows stock of bulk tea has been valued at lower of estimated cost of production(based on estimated production and expenditure for the financial year) and net realizable value.Production of tea not being uniform for the year, stock valuation will be unrealistic if based on actuals. Strictly speaking, this standard cost is nothing but budgeted cost in this case.
  8. Pricing in payment delays:- Those dealing with Govt departments would know the 'last quarter effect' and the invariably delayed payments. Educomp, which handles some ICT in Govt schools reveals in its FY11 annual report that As a proactive measure, at the tendering stage only, cost of
    payment delays are being built into the price of product/ services offered. 
  9. Operating Leverage:- Educomp offers a 'Smart Class' solution to schools where an entire classroom is digitized. If schools purchase the solution for additional classrooms, the rate is presently(in Aug-11) Rs 2.6Lakh/classroom-year versus Rs 4 lakh for new schools. That is because they do not have to install a fresh server.  These classrooms get plugged on to the existing server in the school and quality assurance person from Educomp deployed at the school, remains the same.
I'll update this with new examples when I chance across them. 

Suzlon Jul-11 Rs 216Cr Hansen sale loss-bloodbath or AS-4?

Suzlon manufactures and sells wind turbine generators. Since 2008, it faced quality issues(resulting in warranty payouts & lost sales), higher interest costs(due to ill timed all-cash acquisitions at steep valuations) etc. Its troubles could fill a book, but suffice to say that it has struggled on all fronts till 2008, and was in threat of default on FCCBs till in Jun-11, it lowered the conversion price to Rs 54/share(close to the then prevailing market price). But the topic of this article is to point out a common tactic used by companies to window dress profits. I will present the facts below, it is for you to draw your conclusions. All information is based on the press release of FY2010-11 numbers(http://www.suzlon.com/images/investor_quaterly_result/50_Results_Audited_FY11.pdf) In investing/accounting parlance, a blood bath is booking extra/unwarranted expenses in a period where you can blame the loss on something/somebody else, so that you can show profits in subsequent years. This is generally done in M&As(where reserves are built for 'integration costs') or as happened with a leading Indian bank recently(where a new MD implemented conservative accounting when he took charge in 4Q'2011).
  1. AS-4(Contingencies and Events occuring after Balance sheet date) states that if events happening between balance sheet date and finalization of accounts, were indicative of conditions prevailing as on balance sheet date, then that effect should be given in accounts
  2. On 25 Jul 2011, Suzlon signed the agreement to dispose off 26% stake in Hansen, at a loss of Rs 216 crores. This showed that the book value was overstated by Rs 206 crores, as at disposal date.
  3. If the deal was being negotiated as on 31st Mar 2011 OR if the 26% Hansen stake was showing indications of impairment('over valuation'), then adjusting this loss in FY2010-11 was justified. 
  4. But if the deal was initiated and closed after Mar-11, then this loss should have been booked in the period it happened viz FY 2011-12 only.  
  5. Suzlon opted to book this loss in FY2010-11, thereby boosting the consolidated net loss to Rs 1323 crores(an increase of about 20%+ net loss). But the present FY viz 2011-12 was benefited.
  6. The 1Q'12(quarter ending Jun-11) results showed a consolidated net profit of Rs 60Crores, which certainly buoyed the market sentiment, given the general persistent gloom about USA/EU.
In their defence, I should state two things
  1. The deal might actually have been under process as of Mar-11. But then, it seems odd to me that it closed 4 months later, yet was deemed to reflect conditions prevailing as on Mar-11
  2. The auditors may have taken a firm line and mandated the more conservative approach, with which the company happily complied so that they could boost the 1Q'12 profit by not recording that loss then.
Only the company and their auditors would know which version is correct. But from the investor perspective, one should note that Suzlon is not one to opt for conservative accounting. The FY2010-11 audited press release contains quite a few examples where they have disagreed with their auditors(recognize deferred tax assets despite uncertainty) or avoided booking liability they deem contingent(sub judice electricity duty tariff dispute, FCCB redemption premiun). Hence, giving the benefit of doubt is a bit difficult in this case.

Sunday, August 7, 2011

Avoiding full disclosures-how companies avert the reporting norms of accounting standards

The Indian accounting standard setter(ICAI) sets Indian accounting rules based on global IFRS norms. And they are quite good. However, management still has a discretion to avoid their application, and some do it with impunity. Let us see the examples where this is done
  1. Segment Reporting:- Both for quarterly reporting and annual report purpose, companies are expected to identify their segments(either geographic/functional), and accordingly report allocated segment P&L/assets and liabilities. But companies either take the plea of having merely one reporting segment(like in realty industry) or that it is not practical to identify fixed assets used in the company’s business or liabilities contracted, to any of the reportable segments, as the fixed assets are used interchangeably between segments(Jet Airways etc). Either way, it legally defeats the purpose. One reason companies oppose cost record audits, is that segmental reporting is mandatory under those rules. 
  2. Capacity calculation/inventory valuations:-While the auditor is expected to verify these himself, you often see this phrase 'this being a technical matter, the management certification is accepted'. Such a weasel phrase is not good practice, given that auditors are anyway liable for such blond faith acceptance of management certificates. Now, agreed that the management is often the best knowledgeable in its field. But where the valuations are critical to profit/net worth, the auditor should not abdicate responsibility, and should hire a technical expert(under due confidentiality/independence requirements) to verify the computations. 
  3. Deferred tax assets accounting:- Since accounting data typically exceeds the actual tax liability(due to tax exemptions etc), companies prefer to avoid booking deferred tax on a quarterly basis
  4. Accounting for MTM changes:- Whether it be due to FX, potential FCCB repayment etc, companies claim that they would not account for 'volatile'/'unrealistic' negative MTM movements on derivatives; or even where FCCB redemptions loom near, companies still claim them as contingent. 
  5. Doing related party transactions without fully disclosing fairness to shareholders:- Sample this extract from the auditor's report of Adani Power(to be fair several Indian companies are guilty of this!)-some of the items purchased are of special nature and suitable alternative sources are not readily available for obtaining comparable quotations. This excuse is often adopted for related party purchases, which is quite surprising given India's competitive market.

The reason why public sector company audits take so much time.

This term, my friend and I were doing a project to rank annual reports of Nifty companies. While the private sector cos(barring R-ADAG group cos) have largely released their annual reports within 4 months from year end, public sector companies have not. Only SBI(being a bank thereby subject to 'peer pressure' of releasing accounts within 1 month) has done so, while blue chips like ONGC have not. Why is this so? One cannot even blame the respective Government department for that, because these companies have substantial functional autonomy, and have functioning Board of Directors to approve the accounts.
The reasons are
  1. C&AG issues additional guidelines to the statutory auditor(http://cagofindia.delhi.nic.in/caempanel/directions_2010.htm). Most of these points are anyways checked within the scope of most well planned audits, but some of these guidelines involve substantial elements of operational audit, performance audit and 100% check-which all eats up large amount of time.
  2. Also, while the auditee PSU is bound to provide all information expediently(http://cagofindia.delhi.nic.in/caempanel/annexure-terms2011.htm), the draft audit report must be approved by the C&AG Audit Boards, which may seek the audit working papers as well. This ability to requisition working papers routinely, is unique to such audits, and makes the auditor wary of even the smallest mistakes, thus reducing the materiality limits. 
  3. The C&AG may take its own time to approve the draft audit report, adding its own comments later
  4. Once the accounts are finalized, the concerned Ministry then kicks in with its demand of dividends(as per Finance Ministry edicts). This negotiations with PSU management eats up more time. 
Therefore, delayed circulation of annual accounts for PSUs is not a sign of poor accounting/corporate governance, but is a systemic issue. Investors should keep this in mind. 

Saturday, August 6, 2011

When the going gets tough, the smart guys cook the books-examples of Jet,Kingfisher and others

Warren Buffet famously said that an investor should have shot down the first aircraft that the Orwells flew, so that future investors would not have seen value destruction. In India, the same story of value destruction has emerged, but to compound the industry woes of economy dependence, LCC price wars, ATF etc; some companies are not above cooking the books. Following are some examples from the FY11 press releases/annual reports, for the financial reporting period ending Mar-11. The facts speak for themselves, and bring out why accounting risk is quite high in this sector, and for some business houses in particular.
  1. Cherry picking accounting rules which allow favorable treatment-even before their final adoption: Kingfisher airlines readily adopted a draft accounting standard, to reduce its losses by Rs 37 crores. This may seem good practice(early adoption) but the company does not show such enthusiasm for other proposed rules(like IFRS itself!). And going by the management judgement on deferred tax assets, one must wonder the wisdom of this choice-despite the 'independent expert' view. If the expert was confident of its view, it should have allowed itself to be named. The note reads 'The Company has adopted the Exposure Draft on Accounting Standard - 10 (Revised) Tangible Fixed Assets which allows costs on major repairs and  maintenance incurred to be amortized over the incremental life of the asset..Had the Company not adopted this method of accounting, the loss before tax for the year and the loss after tax for the year would have been higher by Rs.3,726.83 Lacs  and Rs. 2,517.66 Lacs respectively..This revised accounting policy has been confirmed by an independent expert and in the opinion of the management, this accounting treatment has resulted in a fair depiction of the working results and the state of the affairs of the Company.'
  2. Accounting for brought forward tax losses despite track record of losses:- Kingfisher Airlines in their Mar-11 press release announced that, Deferred Tax Asset is recognized on account of unabsorbed depreciation and business losses for the year ended March 31, 2011 aggregating to Rs. 49,341.80 Lacs. The management is of the opinion that there is a virtual certainty supported by convincing evidence against which such deferred tax will be realized. I do not know of any other Indian company, with comparable loss record/industry prospects, that has boldly felt that it will make enough  taxable profits in reasonable time to offset these losses.
  3. Shifting depreciation method from WDV to SLM:- This typically results in lower depreciation expense and higher profits, atleast for the initial years. So Jet Airways discloses that . In order to reflect a more appropriate preparation/presentation of financial statements, the Company has changed the method of Depreciation on all owned tangible assets (including Simulators) other than Aircraft from Written Down Value Method to Straight Line Method w.e.f. I st April, 2010 and the surplus arising from retrospective computation has been accounted and disclosed under Exceptional Items for the Year ended 31 st March, 2011. This bottomline boost amounted to Rs 135 crores, as compared to PAT of 48crores loss.
  4. Recording LCC investments at book value despite heavy equity erosion. This is not unique to airlines, but even where they are not market leaders(Jet Lite has just 7% market share), they are very optimistic. For instance, Jet invested nearly Rs 3200 crores in Jet Lite, yet is not accounting for the value erosion. Note that the valuer is unnamed, also that mere expectation of turnaround without a stated timeframe, is used to defer loss recognition.  The justification reads as follows The Company has equity and preference investments aggregating to Rs. 164,500 lac in Jet Lite (India) Limited, a wholly owned subsidiary, and has advanced an interest free loan amounting to Rs. 1,52,951 lac as on 31 st March, 2011. A reputed valuer has valued the equity interest in the subsidiary as on 31 st March, 2011 based on its business plans, which supports the carrying value of such investment The Company continues to provide financial support to the subsidiary's operations to further such business plans and expects it to turnaround. Accordingly, the subsidary's financial statements have been prepared on a "Going Concern" basis and no provision is considered necessary at this stage in respect of the Company's investments and loans outstanding from the said subsidiary
  5. Extending the financial year erratically:-When you expect to report a bad year, what do you do? Delay the release of annual report(R-ADAG companies), or extend the accounting year. In May-11, Mafatlal Industries initially had extended their accounting year from May-11 to August-11, but buoyed by the sale of land, they preponed it to June-11! This travesty is documented in their May-11 quarterly results press release. The Company in its Board Meeting held on 9th  May, 2011, had extended the Financial Year 2010-11 of the Company by three months from ending on 31st May, 2011 to ending on 3I st  August, 2011. The Board of Directors of the Company have now passed a resolution on 27th  June, 2011, for change of Financial Year 2010-2011 to end on 30th  June, 2011 instead of 31st  August, 2011. In view of this, the Financial Year of the Company would be for 13 months period i.e. from 1st  June, 2010 to 30"' June,2011 in modification of the Resolution passed on 9th  May, 2011..

Man lives on hope-examples of 'going concern disclosures'

Financial statements are generally prepared on a 'going concern' basis, which assumes that the company does not have the intention(or the necessity) to enter liquidation, or substantially curtail scope of its operations. If it does, then the balance sheet will be prepared as per market values/liquidation values. Typically, auditors give leeway to companies even with protacted history of losses. As investors, if you notice a going concern note by management/auditors, then do take note that the auditor is doubtful about the company's ability to continue for long in business, and has therefore compelled the management to explain their plans to investors. Below are the going concern disclosures of some troubled companies-Jet Airways, Kingfisher Airlines(industry woes) & Tata Teleservices(Maharashtra)-where balance sheets/P&L are awash in red ink. Note the appeal to industry woes, economic upswing and operating efficiency promise! The story is consistent!
  1. Tata Teleservices:- The accumulated  losses of  the Company at  the close of  the year have exceeded  its paid-up capital and reserves. This, however, is not uncommon for telecommunication service providers, due to the high operation costs and on account of  the  industry being  inherently capital  intensive. However, the Company  is consistently making operating cash profits over  the past  few years.The subscriber base of  the Company has  further  increased with  the  launch  of  services  using  the GSM  technology during the previous year. The Company has also received sanctions  from  banks  for  additional  long-term  funds  for future  expansion.  Further,  during  the  current  year  the Company succeeded in winning the bid for 3G spectrum in Maharashtra circle (including Goa and excluding Mumbai) and has also commenced 3G services. Accordingly, based on  the aforesaid  considerations,  the Company is confident of it's ability to continue it's business as a going concern and the accounts have been prepared on  that basis. Note the reasons (industry characteristics, bank sanction, new revenue streams etc). These go beyond the typical MD&A fluff. 
  2. Jet Airways:- The Airline Industry was adversely affected by the general economic slowdown witnessed globally in the year 2008.This coupled with high fuel cost significantly impacted the performance and cash flows of the Company and its subsidiary resulting in substantial erosion of the net worth. The Management has been constantly implementing initiatives to improve the operating results through cost control measures, route rationalization, leasing out aircraft
    etc. During the financial year 2010-11, the Company improved its operating performance consequent to passenger traffic returning to normalcy and reflected operating profits in the first three quarters. However, as a result of significant increase in the crude oil prices not matched by increase in fares, the Company could not maintain its profitable performance during the last quarter of the year. This, in the view of the Company is purely temporary as the fuel prices have now subsided and going forward, the Company expects to perform better. The Company is also
    exploring options of raising finances to meet its various short term and long term obligations including financial support to its Subsidiary – Jet Lite (India) Limited. These measures would result in sustainable cash flows and accordingly continues to present these financial statements on a going concern basis, which contemplates realization of assets and settlement of liabilities in the normal course of business.
    These reasons, to me, seem a bit shaky, and I think the auditors allowed this going concern to persist due to the fund raising plans
  3. Kingfisher Airlines: - The Company has incurred substantial losses and its networth has been eroded.  However, having regard to improvement in the economic sentiment,  rationalization measures adopted by the Company, fleet recovery and the implementation of the debt recast package with the lenders and promoters including conversion of debt into share capital, these interim financial statements have been prepared on the basis that the Company is a going concern and that no adjustments are required to the carrying value of assets and liabilities. While the debt recast happened post Mar-11, it would have allowed enough evidence to the auditor for proceeding. 
Yet, this optimism has been rewarded at times. For example, the erstwhile textiles giant Mafatlal Industries was brought to its knees in 2002, and was administered under the BIFR since then till 2010. During ALL those years, the company prepared its accounts on going concern basis, hoping that the scheme would work. And recognizing that they are worth more dead(land bank!) than alive, they have begun to sell land. Take this note from the May-11 press release for example Based on the Audited Accounts as on 31sl
 May, 2010, wherein net worth of the Company has turned positive, Company made an application to the Board of Industrial & Financial Reconstruction (BIFR), for deregistration of its reference. BIFR vide its order dated 19th  August, 2010 discharged the Company from the purview of Sick Industrial Companies Act /BIFR. Accumulated loss of the Company has also substantially reduced over a period of last 2 years; further the company subsequent to the quarter ended 31st May, 2011 has concluded an agreement for development of leasehold land at its Mazgaon Unit, (Refer note 1 above). Accordingly, accounts are prepared on going concern basis. 

    Takeaway;- This may seem just management spin, but when the auditor is afraid enough of its own liability to demand an explanation from management, it is time to critically examine the investment rationale, despite the various valuation stories spun to investors(Like EV/EBITDA etc). Invest with eyes wide open!

    Lending agreements-increasing trend of outsourcing monitoring to professionals

    Conventional financial theory holds that financial intermediaries(like banks) add value('spread'/NIM) by aggregating deposits and lending them to qualified borrowers. For these loans to be profitable, banks should have the expertise in credit risk assessment and monitoring. But the past few years(decades?) trend seems to be negating this theory. While banks are focusing their energies on gathering deposits(more channels, multiple access mechanisms, marketing) and processing loan applications faster('retail loan factories'), their response to scams seems to outsource that monitoring function to a professional. For example
    1. Some banks give 0.25%-0.5% interest rate discount to their SME borrowers with credit ratings. 
    2. Stock audits/financial audits(where not otherwise done) are made mandatory for those with working capital/other operating facilities.Incidentally, this is the mainstay of many a SME practice.
    3. For borrowers with multiple bank relationships('consortium lending etc), RBI has mandated a compliance certificate to be issued certifying governance issues, no fund diversion etc. Interestingly, this circular also contains a best practice of different statutory/internal auditors for group companies, where facilities cross Rs 50crores.
    4. Often, the audit clause contains a 'Big 4' auditor appointment insistence-this is true of the Indian private sector banks, but this trend seems going down though. 
    5. In additional to the general purpose financial statements, auditors are often asked to sign a compliance certificate(under the lending agreement) which contains proforma ratio calculations, covenant compliance affirmation etc. When the auditor is tasked to do this(albeit for extra fees), he is in reality doing the monitoring function of the bank.
    6. Auditor/CAs are often asked to certify the utilization of the earlier sanctioned funds, before the next disbursal is approved. 
     Conceptually, there is little quarrel with the proposition of 'bundling of services' or delegating to experts. When the auditors/credit rating agency are expected to know the client well and perform their tasks with due diligence, then the bank is entitled to rely on them. The only possible issues with this, is that the processing fee/interest rates should reflect this reduced risk, as well as reduced costs for bank. Otherwise, the benefit from these activities directly flow to the bank's bottomline. Btw, the professional referred to in this are practising CAs/CSs/CWAs-most of whom can do the above work. Still, the statutory auditor is preferred for most of this.

    Safety first-how IRDA regulates investment management in insurance industry

    Given the vast AUM of the insurance industry, investment management is a big business there. So the regulator(IRDA) has guidelines for that, which Chartered Accountants are asked to certify the company's compliance in that regard. Some of these guidelines are;-
    1. Seperate front office from middle office/back office. Former reports to CIO and latter report to CFO, so CIO cannot hide trade data
    2. Automatic data transmission from Front Office to Middle Office w/o scope to manually edit. Back office cannot rectify wrong data but only reject it
    3. For AUM>500Cr, fund manager cannot be the trader
    4. Outsourcing ban with limited exceptions-that too to be paid for by shareholders fund not by policy holders. At first blush, it seems unfriendly(why insist on expense in house handling) but then one should remember that outsourcing core competency(investment management IS one for this industry) is frowned upon by regulators, and by others.
    5. For security not traded within past 30days, book value used. Much stricter than SEBI which allows DCF valuation with appropriate liquidity discount. 
    6. Mandates extensive use of automation, especially for cash management and generation of routine/exception reports. Also, investment limits(sector/caps/liquidity/mix) are preset in the system, to ensure alerts before the trade happens. IRDA mandates this.
    To their credit, the sector has never had a publicly reported major scam. So IRDA does seem to be on a right track in this regard.

      The cartographic analogy to accounting.

      Accounting is often critiqued as being inexact, outdated and not detailed enough(wrt non financial data)/too detailed(wrt financial instruments). No smoke exists without fire, so there's an element of truth in this. But if one understands accounting as a 'map' of the underlying terrain 'operations', then things begin to fall in place. There are many parallels between the two

      What Map Accounting
      Purpose Understand terrain without visiting it Understand company as an outsider
      Detail Depending on the 'scale' Depending on materiality level
      Other info travelelogues/lonely planet non financial disclosures
      Assurance Reasonable-because these are often not updated often plus on ground situation may vary Reasonable-because 100% check never possible
      Skills needed Art and Science Art and Science
      Language Symbols/colours Accounting Standards

      This list is not exhaustive but good enough. So those of you who have referred an atlas and then subsequently visited that place, would get an idea of how the financial statements(map) may vary from reality(ground!)

      Retail investors face more risks than while driving cars-so make entry test mandatory?

      Umpteen studies prove the same point-that investors have a very low chance of beating the market. Whether professional fund managers or amateur retail investors, they more often than not fail to beat the market. For every Warren Buffet out there, there are millions of losers(losers financially-not counting the risk lovers, education gained etc). This is more true for the derivatives market, where leverage magnifies the exposure at risk. While SEBI now insists on brokers collecting income proofs of their clients/getting clients to sign risk disclosure documents, there is nothing to ensure that investors understand the 'rules of the financial road'-risks/common mistakes/financial planning/financial literacy tenets etc, before investing. One needs a license even to drive a Rs 1 lakh nano, but not for investing lakhs in the stock market.

      For financial intermediaries, NISM(and NCFM) have successfully scaled up curriculum and tests to ensure a basic level of knowledge, commensurate with the risks/products sold. But for investors who often commit a good chunk of their savings to the market, there is no such mandatory testing. One may argue that interested investors will learn from newspapers/financial press/magazines/internet etc, but they may be mislead by the wrong sources, also it may be 'too little too late'. While financial literacy is spreading via CBSE curriculum/RBI comics/investor talks/NSE tieups with colleges etc, one needs to deliver a big-bang training, to ensure that people know-and more importantly acknowledge-the various details/risks of their decision to do active investing.

      Such a test could be made compulsory for those with broking accounts, private wealth management coverage etc, and then rolled out to all. Exemptions are not desirable-because often even commerce graduates may not have the right concepts. The format could be a MCQ test with caselets, in multiple languages(Hindi/English/State language), with the expense borne by the investor protection fund of the stock exchanges. It could cover the basic NCFM modules content + awareness of frauds/dangers in common investor actions like day trading, margin trading, blank POAs etc. The benefits of this are
      1. Lesser chance of 'noise traders'
      2. Brokers will be happy as arbitrations become easier('investors cannot claim ignorance')
      3. Financial planners prospective client base will go up
      4. Basic financial products(index funds, pension funds, term insurance) become more popular. 
      5. General financial education level improves.
      If brokers do this voluntarily(say sponsor client NCFM test), then overall benefit would happen, in my view. But that being unlikely, that regulatory prod seems necessary.

      Converting Capex to Opex-can infrastructure lessons work in finance?

      During my Transport Infrastructure(TI) classes here at IIM-A, Prof G Raghuram introduced the class to a framework of analyzing infrastructure as three distinct segments, each with its own risk-return tradeoffs, competition characteristics and investment rationale. They are Terminals/Right of way/Rolling stock. This is further elaborated below(note that essentially they have the principle that specialist operators take over capex headache, and charge opex to the users).
      1. Right of way:- Getting the license to lay cables/fly airlines/build towers. Typically, this involves liasons with regulators/local authorities/government. Usually a legal monopoly, and if a private sector player gets it, it becomes a natural monopoly due to the poor economics of duplication.
      2. Terminals:- These are the fixed departure/termination points between which rolling stock(vehicles etc) moves. They supply all the operating infrastructure and deftly schedule competitors. 
      3. Rolling Stock:- Planes, buses, coaches, wagons, ships fall in this class. They are the actual revenue earning assets, which depend on the first 2 segments for being able to operate. There is no voluntary open access at all here, and maximum customization/differentiation is possible. Usually unregulated(wrt returns) and the sweet spot for private players due to low cost of entry, low entry barriers etc. 
       The above framework applies to nearly all infrastructure sectors whether it be telecom(laying wires/towers/handsets-spectrum), rail(tracks/stations/coaches), ships(flags/ports/ships). The underlying principle at play is that asset ownership/operation, and asset utilization require drastically different competencies. While fixed asset management would need maximum utilization(open access), efficient cheap service etc; its utilization would depend on competitive dynamics and the ease of entry for market players. Earlier, regulators used to bundle the license('right of way') with the necessity to set up one's own physical infrastructure('terminals'/'rolling stock'), but now the realization has set in that operating the asset may not need physical assets-sharing agreements can take care of that. Hence we have toll collection companies, MVNOs etc, who bring their expert skills to get the best out of the infrastructure.

      In case of banking/finance, this paradigm is slowly getting in place. Take the following examples:-
      1. Hedge funds can now use their intellectual capital('rolling stock') to access the prime broking infrastructure of their investment banking competitors
      2. Insurance companies/mutual funds can piggyback on their banking partners to sell products, instead of taking the pain to set up branches. 
      3. For expanding the access of retail banking, RBI suggests bank agnostic banking correspondents, who will have machines able to operate any bank's account.
      4. The idea of intraprenuers within organizations/financial supermarket in a retail bank branch, hinges on the idea that creative ideas/cross selling can best utilize the infrastructure already in place. 
      5. ATMs('terminals') are now nearly open access due to the number of free transactions(5/month) for ALL banking customers. Hence, new banks(aka 'rolling stock'!) can devote less resources to this aspect and focus on customer service and innovation
      6. Incubation centres/Industrial parks/business centres/single window clearances(presently non banking scenario only) focus on this same principle of relieving headache of the formalities/heavy investments. 
      7. Outsourcing trend seen in financial services(IT/Manpower/office space/accounting) and elsewhere, is reflective of this trend,\
      This post IS a bit random but should hopefully spark some thinking

      Friday, August 5, 2011

      Great Offshore-structuring compensation to escape Government approval.

      Whenever the Government tries to limit executive pay, self appointed defenders of Indian corporates(academics/media/industry leaders) rally against the intrusion of government into the private matters of companies. What people often forget(while seeking Western type freedom to pay 'top management') is that
      1. The number of FMCs(Family Managed Companies) in India, is much more than abroad. 
      2. The use of remuneration consultants etc to justify pay rarely happens in India
      3. While appointing family members to executive roles in companies, rarely is a pretense even made of 'merit based appointment'. Instead, succession plan reasons etc are given. Fine, owners have that right I guess. But why pay top dollar in those cases?
      Take the example of Great Offshore. One of its promoter's relatives Ms Sukriti Kumar is a MBA In Entrepreneurial studies from some USA college,  with some experience(manpower related is my guess given Hewitt Industries). Adequate details are not given about her experience in Bharati Shipyard, that qualifies her for this high pay of Rs 3 million/year. Given how companies would flaunt the credentials of their relatives, one must assume the worst. And I'm certain that for this compensation, attracting India's best college alumni would not be an issue, for a 'corporate planning role'. Read the resolution below, and notice how carefully they have designed the pay to avoid crossing the statutory ceiling. If the ceiling was even 2x of its current limit, I'm confident that the pay package would have been that. By not crossing this limit, were they afraid of seeking Govt approval? With such practices, Indian cos show a regrettable lack of adhering to corporate governance codes.