Financial reporting and taxation a zero sum game?

Reposting from another blog of mine http://apoliticallyincorrect.blogspot.in/2012/10/financial-reporting-and-taxation-zero.html  At the risk of repetition, views purely personal.

Tricks Indian companies play to fool investors now-I

This time of the year is earnings season in India when companies declare their full year results for the financial year Apr11-Mar12(most companies follow this year end due to the tax laws mandating this year for assessment purpose, but many others follow different year ends like June, July, Dec and so on). While reading several earnings releases, I observed some interesting things which I share in this post

1. Delaying the release of results:-While most companies do not publicly disclose their financial reporting calendar, if a company has delayed reporting its earnings significantly as compared to previous years, that is a clue of financial distress. The company may be cooking its books or trying to get financial support to avoid being singled out for 'going concern risk'. Recently, this was done by the R-ADAG group companies, GTL group and others.
   
2. Extending the financial year:-Companies do this to buy time or just to avoid reporting poor results(hence add a quarter or two to make the 'year' better'. Or else, for the same reasons as explained above(i.e 'going concern risk'). I suspect that Bartronics has sought an extension for the same reason.
3. Limiting auditor's scope:-In case of Shree Renuka Sugars, Bartronics etc, the auditors audit less than 20% of the revenue/assets/cash flow, leaving the rest to other auditors. While accounting and auditing norms permit this and have standards on the auditor's duty in this behalf, the fact remains that audit risk goes way up in this case as auditors may miss out on channel stuffing and other unusual transactions.
4. Releasing interim 'unaudited results' rather than audited/reviewed results:-While Indian listing regulations permit a maximum 10% deviation in significant items(revenue/earnings etc) of the actual audited numbers from the 'interim numbers', that leaves significant scope for companies to tinker around with accounting estimates, especially for those hovering on the verge of losses. While I''m yet to prove any such case, I'm on the look-out for it this season.
5. Changing presentation to hide details of unusual items:-for instance, Bartronics(again!) had an 'other income' exceeding its operating profit but did not explain that details anywhere in its earnings release/presentation. and why would it, it is better off for investors to assume it is operating profit without delving too much into the details.

Stay on the lookout for tricks in disclosure/presentation. More on this later.

CA-Chartered Accountants(CAs) or Creative Accountants?

As the lone CA fraternity member among a host of BEs, I often take some good natured ribbing about the ethics, flexibility, fraud detection ability etc of CAs. While no profession of significance is free from its issues(read my post on doctors here http://apoliticallyincorrect.blogspot.in/2012/01/hippocratic-oath-or-hypocratic-oath.html), the fact remains that events like Satyam in India, Lehmann in USA, Olympus in Japan etc have thrown the spotlight on both the corporate accounting staff as well as their auditors. In that light, I thought it apt to dissect the ways in which CAs are seen as creative accountants

1. Hollywood accounting:-Earlier, Hollywood stars etc used to settle for a cut of the film profits. But after a host of creative accounting practices like cost allocation, gross vs net, excluding rights income etc, they gave up the effort of auditing it and instead settled for a share of the gross. Yet, this phrase is a club to beat accountants over whenever the topic of creative accounting comes up
2. Financial projections/models for M&As/banks/IPOs:- Noone is perfect and forecasting is filled with its share of bloopers and inaccuracies. Yet, like fairness opinions on IPO M&As(have you ever seen one against the interests of the person who commissioned the opinion), these financial projections tend to be upward biased and often start with the end in mind, adjusting inputs to arrive at a definite NPV/IRR/value. When these projections are proved wildly unrealistic resulting in IPO prices tanking/bank NPAs racking up/M&As not realizing projections etc, then those behind those financial models take their share of the heat. 
3. Transfer pricing:-As ICAI explains in its guidance note on transfer pricing audit(http://220.227.161.86/2102692E_tp_dtc.pdf), there is a general belief that multi-national corporations, in an effort to manage and minimize their global tax outflows, have employed creative transfer pricing approaches in the context of flow of goods, services, funds, intangibles. But to the extent such transfer pricing impedes corporate governance(say 2 sets of books are maintained) and distorts performance measurement/resource allocation, it is self defeating.
4. Innovative accounting driven transactions:-Be it financing via sale and buyback, merging subsidiary with self to write off impairment losses against reserves, using leases to take debt off the books, Lehmann's famous 105repo transaction etc, there is no dearth of examples of how creative accounting has played its bit. 

However, every profession has its share of err..practices not in public interest, as well as bad apples. That should not tarnish the vast majority of professionals who do their work honestly. 

How Indian companies engage in diversion of funds, and how to spot/avert it

“Companies turn sick, lenders turn sick, but promoters rarely do”-Prithvi Haldea

The inspiration of this blog post came from the above quote of Prithvi Haldea, who also wrote an interesting article on the topic (http://www.primedatabase.com/ie_ph_59.asp). The observations here from my own observations, and a variety of credited sources.

1.      Examples

a.      Satyam:-By creating 6000+ fake salary accounts, Raju apparently(since case is still murky and sub judice) diverted those ‘salaries’- Rs 6000 crores to group companies for purchasing land in Hyderabad. Now, those companies have filed counter suits(!) for getting 'their' intercompany loans back, and the issue is subjudice.

b.     SEBI IPO order Dec11:-Several companies were found misusing or diverting issue proceeds.Besides banning promoters of seven companies, the regulator also suspended three BRLMs from undertaking any new share sales.These include PNB Investment Services, the merchant banking arm of state-owned Punjab National Bank ,Atherstone Capital and Almondz Global Securities. The methods of fund siphoning included inter-corporate deposits, and diversion of IPO proceeds from what was stated in the offer document

c.     Banks:-An oft cited reason for default is poor loan monitoring thus allowing borrower to siphon away the funds.

d.      Vanishing Companies:-The post IPO crash of many companies seems to indicate that the companies remain but their funds vanish into thin air. Be it the plantation companies of the 90s, realty companies of the 2000s or the private wealth management firms/retail recently, some sector or the other invariably destroys shareholder funds.

2.      Checks and balances(including RBI six-step approach to prevent fund diversion)

a.      Monitor fund utilization-mandated for IPOs over certain limit, extended by SEBI to cover warrants money/preferential issues as well. In Apr-11, the MCA has  given ROCs a comprehensive check list of the areas they need to check  on end use of IPO money

b.     meaningful scrutiny of the periodical progress reports/periodical scrutiny of accounts

c.      regular visits to assisted units and inspection of securities charged/introduction of stock audits

d.     initiation of prompt action if warranted, including withdrawal loans

e.      examination of all aspects of diversion of funds during internal audit

3.      Red Flags for investors

a.      Large cash balances not reflecting requisite interest income.

b.     Investments in group companies/associates later written off/’under court dispute’

c.      Long outstanding intercompany loans/deposits/advances

d.     Large amount of IPO proceeds as ‘General Corporate Purposes-these can be more easily diverted without issues

e.      No Quotations obtained for equipment/purchases-this may mean management is not serious about the purpose.

f.       No Lender appraisal of the Project-this may mean 'lemons' problem

g     M&A advisory fees disproportionate to market standards(for example the Japanese company Olympus paid its M&A advisor 33% of a deal value, the deal was later found to be without commercial rationale)

h    Very large note disclosing related party transactions-more the merrier does not hold! 

Essar redefines factoring/assignee to save promoter entities from guarantee

It is not often that I cross-post items across blogs. But having spent 2-3hrs to piece the Essar puzzle together, I thought that the final analysis on the 27% yielding Essar bonds maturing 2016, deserved a wider audience. A rather longish post, but well worth the read(http://specialsituationsindia.blogspot.com/2012/01/27-yield-essar-energy-425-2016.html). For those of you impatient to get to the factoring bit, just fast forward towards the end. For best results, read the other post on Essar, under the same tag.

Can an Indian investor rely on signalling from FIIs, banks, auditors or volumes?

On 21st September 2011, SEBI issued an order , detailing how GDRs were used to manipulate stock prices. Apparently, the companies in question has schemed with a few issuers and Indian brokers, to convert the GDR into shares, indulge in circular trading and then sell those shares to unsuspecting retail investors, who saw this conversion as sign of confidence and due diligence by supposedly well informed FIIs. For more on this, read the SEBI order here(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1316607187418.pdf)

But if the investors thought they could rely on trade volumes of Indian investors, then there was another thing coming. Those tracking the markets would remember the tremondous rise and fall of Kwality Dairy, after SEBI discovered the existence of a cartel engaging in circular trades. That case should warn anyone who invests in penny stocks on momentum driven trading strategies(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1314688048292.pdf) 

But surely, one can rely on banks and auditors, right? Banks sanction loans to company on the security of inventory/current assets, and appoint stock auditors to periodically examine the asset quality. So should not secured loans on current assets be a good signalling practice for the company's asset quality? My classmate and friend Manpreet Singh(who blogs at http://www.the-value-stock.blogspot.com/) thinks the same thing. But one should remember that banks are not technical experts on valuation, and the mounting NPAs shows that even banks make mistakes. Also, when the auditor of an midcap pharma company(whose inventory counts for 70%+ of its book value) accepts inventory as valued and certified by the management,  then it is a cause for alarm, since that means the auditor is not confident in his own diligence on the inventory. Considering that banks normally take such asset valuation reports from the statutory auditor, I would be wary of accepting secured loans on such inventory, as evidence of the company's asset quality.

And auditor competence apart, the recent controversy over Deloitte's inflating a valuation report on the behest of one of its client's, shows that the issues exposed in the Satyam scam, are still live and kicking. When even Big4 auditors can make mistakes, what about the SME audit firms(like the unnamed auditor of our midcap pharma stock)?

Bottomline:- Unless an investor learns to read between the lines and look for what is there, and more importantly what is NOT there, he's setting himself up for a disappointment.

Cooking the books-the case of Air India MOU

It is a hallowed tradition in the private sector to 'cook the books', whether it be maintaining multiple books for financial, tax and regulatory accounting; fudging proforma metrics etc. In the Union Civil Performance Audit 2011-12 on NACIL, the C&AG lambasted the Govt-AI MOU, stating that the performance evaluation metrics were not designed aptly.
 The Memorandum of Understanding (MoUs) signed between the erstwhile IAL and AIL and MoCA were flawed. The non-financial parameters included in the MoU included minor or insignificant parameters or gave undue weightage to such parameters, at the cost of critical traffic and operating parameters in the airline industry (such as those being monitored by Directorate General of Civil Aviation). This skewed the MoU ratings of IAL and AIL unduly to present a “rosy” picture of performance. The overall combination of financial and non-financial parameters devised for the MoUs were such as to ensure that the MoUs became a meaningless exercise, rarely (if ever) reflecting poor performance, and ensuring lack of effective accountability for all parties concerned

While this would not meet the strict legal definition of accounting fraud, it resembles the infamous metrics used by Groupon in its IPO prospectus, which had a similar purpose for showing a rosy picture.

The takeaway from this sordid episode is that while reading the Result Framework Document(RFD) uploaded by each ministry on the site, try to exercise your judgement in whether it focusses on critical outcomes, or merely tries to dress up the performance. This will need some technical knowledge and extra effort, but if media attention on AI MOU like cases prevents another AI, it would be worth it