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Saturday, August 6, 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!

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