Safal Niveshak Mastermind-Lesson 29
Safal Niveshak Mastermind-Lesson 29
Safal Niveshak Mastermind-Lesson 29
“What has been will be again, what has been done will be done again;
There is nothing new under the sun.”
~ Ecclesiastes
Thus begins the preface of the landmark book Financial Shenanigans, written by
Howard M. Schilit, whom I had quoted at the start of Lesson 22 where we began the
section on financial statement analysis.
I had also mentioned then how the issuers of financial statements – the for-profit
companies – have their primary objective as maximizing shareholders’ wealth, and
not educating them about their financial condition. Now how can a company
maximize shareholders’ wealth? One way is by reducing its cost of capital.
Simply stated, the lower the interest rate at which a company can borrow or the
higher the price at which it can sell stock to new investors, the greater is the wealth of
its shareholders.
From this standpoint, the best kind of financial statement is not one that
represents the company’s condition most fully and most fairly, but
rather one that produces the highest possible credit rating and price-
earnings multiple.
Don’t get me wrong here. All companies and their managements are not there to
scam you with incorrect financial information. In fact, while most companies act
ethically and follow prescribed accounting rules when reporting their financial
performance, some take advantage of gray areas in the rules (or worse, ignore the
rules altogether) in order to portray their financial results in a misleadingly positive
way.
Management’s desire to put a positive spin on financial results has been around as
long as corporations and investors themselves. Dishonest companies have long used
these tricks to prey on unsuspecting investors, and it is unlikely that they will ever
cease to do so.
As King Solomon observed in the book of Ecclesiastes, “What has been will be again,
what has been done will be done again.”
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With the never-ending need to please investors, the temptation for management to
exaggerate the positive through the use of “financial shenanigans” will always exist.
The lure of accounting gimmickry is particularly strong at companies that are
struggling to keep up with their investors’ expectations or their competitors’
performance.
And while investors have become more savvy to these gimmicks over the years,
dishonest companies continue to find new tricks (and recycle old favourites) to fool
investors. Amidst this, it has become ever more important for you, as an investor, to
be very careful while reading a company’s financial statements. In fact, there is no
way you can invest your hard earned money in a business whose financial condition
you don’t understand.
Financial Shenanigans
As per Investopedia, financial shenanigans are…
Depending on the scale and scope of the shenanigans, the repercussions can range
from a steep sell-off in the stock to the company’s bankruptcy and dissolution.
• Was India’s 4th largest IT services player, and thus a torchbearer for things
that were right with this country
• Employed 50,000+ employees – a too-big-to-fail types
• Earned annual revenue of US$ 2+ billion
• Won an award for being among the best in the world for corporate governance
(and just 2 months before the scam broke out)
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So, while Satyam was winning accolades in India and worldwide for its business and
so-called corporate governance, its CEO Ramalinga Raju was busy creating Rs 7,000
crore worth of fake bills to siphon cash out of the company. What is worse, the
auditors and independent directors did not come to know about it, or so they
claimed!
Professor Palepu seemed to have had a lapse in good governance judgment. While
serving on Satyam’s board, he also accepted “special remuneration” of nearly US$
200,000 in 2007 for providing professional services.
While I am not questioning either the quality of the professor’s services or the
fairness of the amount of remuneration received, it is hard to see how Palepu can be
considered “independent”.
Anyways, coming to Satyam’s financial accounts, the huge cash that the company’s
annual reports stated did not exist in reality!
In January 2009, Raju admitted to inflating cash and bank balances by Rs 5,040
crore, overstating debtors’ position of Rs 2,650 crore as against the actual figure of
Rs 490 crore and non-disclosure or understatement of liabilities worth Rs 1,230
crore.
Now scams like Satyam – and others that erupt at regular frequency in India and
around the world – lead one to ask two simple questions
It Starts Small
Typically, a CEO does not wakes up one morning and says, “I feel like adding 5,000
crore rupees to our revenue today.”
He, alongwith his trusted cohorts (often they also include auditors), usually start by
fudging the number a little–and then it grows.
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The fiddle is easy to rationalize at first. Managers typically have confidence in their
skills and believe that their company is fundamentally sound. Given that, it’s easy to
rationalize that while we’re just a little short on the numbers now, we will make it up
in the future, and nobody will know.
It gets out of control. When the company is unable to make up the gap, a larger
distortion is needed to cover it up. This in turn creates pressure to deliver even better
results – which leads to bigger cover-ups, and so on. This is exactly what Satyam’s
Raju indicated of in his letter disclosing the fraud…
Now, when an accounting fraud – like Satyam – involves reporting cash that is not
there, it is typically the result of adding fraudulent transactions, such as cash sales, to
customers that never happened. These types of transactions should have been
audited to assure their legitimacy.
In the case of Satyam, the auditors signed off on the financial reports, raising
concerns that even the increased auditing standards imposed may not be sufficient.
Amidst this, we as investors can only hope for improvements in governance, audit
and legal penalties, as that would disincentivise managers from committing such
frauds.
Identifying Shenanigans
Let me now bring you to the second question I asked above – How can a small
investor see red flags when experts have often failed to do so?
You see, it’s not about being a small investor or a large investor / expert analyst /
fund manager to be able to spot financial misdoings a company may be committing.
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You need to have a checklist of things that can go wrong and the integrity to go
through that checklist before you commit your funds to any business, however good
or honest it may seem.
You must have a checklist of key financial shenanigans that companies indulge in, so
that you can identify a red flag when it appears while you are going through a
company’s annual reports and financial statements.
Now what are the kinds of shenanigans you must keep an eye on?
Well, some are very explicit and would appear even if you read an annual report
while watching a football match. Like this one from a Kolkata-based steel company,
Vikash Metal and Power, which reported a “unique” loss in its FY12 annual report.
“What’s unique about a loss?” you may wonder. Well, it was on account of a unique
“robbery”!
Your second question – “What’s unique about a robbery?” Well, see Note 25 of the
company’s accounts…
Not just the company’s plant and machinery, and stock, the robbers also took away
the company’s building!
This led to a dramatic reduction in the company’s fixed assets and inventories and
wiped out its entire equity. Not surprisingly, even the auditors endorsed the robbery.
Anyways, as I mentioned, this is a fraud that is visible to the random eye. But most
shenanigans are not so much in the open, and must be searched for in the annual
reports and financial statements.
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I will cover the first – Earnings Manipulation Shenanigans – in this lesson while
taking up the remaining two in the next.
Imagination has inspired talented scientists, for example, to diagnose the unknown
and find cures for diseases. Similarly, technological entrepreneurs like Bill Gates and
Steve Jobs have imagined exciting ways create new products, such as Microsoft’s
Windows and Apple’s iPad, that enhance our enjoyment of life.
Occasionally, though, the imagination can run amok. Many corporate executives
have given imagination a bad name when they’ve used theirs to get too creative with
company revenue and profits.
Anyways, here are the key ways companies manipulate their earnings –
Case 1: Take the case of Indian real estate companies. As per Indian accounting
laws, real estate developers are required to recognise revenues from ongoing projects
based on the ‘percentage of completion’ method. Under this method, revenues and
expenses of long-term contracts (which span more than one accounting period) are
recognized quarterly/yearly as a percentage of the work completed during that
quarter/year.
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Now, revenues would be recognised when the actual costs incurred to-date exceed
some percentage (25% as per Indian accounting laws) of the estimated total project
costs. Given that this practice involves a lot of estimates, the percentage of
completion method allows accelerated revenue recognition on the Income Statement.
As for real estate developers, given that revenues from ongoing projects form a
significant part of the total revenues reported by real estate developers (for example,
around 65% of the reported consolidated revenues by Unitech in FY13 were revenues
recognised on ongoing projects under the percentage of completion method, up from
26% in FY09), this methodology can be misused to inflate the reported revenues and
the resulting profit.
What is more, while some companies only include construction-linked expenses (i.e.
land conversion costs, depreciation of plant & equipment, etc) in determining the
stage of completion, others (like Unitech) include the land cost as well.
Given that land costs could form a significant part of the overall project costs
(especially in tier-1 cities), companies that include land cost in determining the stage
of completion can easily overstate their top-line by recognising revenues from
projects even before they start realising revenues from their customers which is
usually linked to construction.
Like see this chart for Unitech, which shows how its receivables have risen sharply
over the years, even while income has been stagnant and falling.
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This is certainly a red flag you must watch out for. Also note that Unitech’s receivable
days have increased from 64 days in FY08 to 239 days in the first half of FY14, which
again is an indicator of red flag as the company has been aggressive in booking
income even as cash from previous bookings is not coming in.
Also, when you read the company’s annual report where it shows almost zero export
revenues, and then you read its “About Us” page that mentions the following, you
know things are really shady…
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Bartronics can address that as we are built from the ground up to solve that for
you. Independent of the size or complexity, or handling your largest, most complex
projects, Bartronics helps you derive measurable outcomes that you have always
been looking for, from business and IT investments.
What is more, its cash profits – as reflected in Cash Flow from Operations – have
been constantly lower than its operating profits, again suggesting aggressive booking
of revenue even as cash was not coming in.
• Receivable days ratio: This is another way of looking at the first measure
highlighted above. A high ratio should raise concerns about the quality of
revenues recognised, because a high number likely means that the revenue
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increase might have been achieved by relaxing credit terms (see the analysis of
ICSA and Bartronics above).
Like, take the case of R&D expense. As per generally accepted accounting principles,
expenditure incurred on research should be expensed when incurred, i.e., no part of
such an expense should be recognised as an intangible asset and thus amortized over
a number of years. Expenditure incurred on development can be recognised as an
intangible asset only on fulfilment of certain conditions.
However, companies capitalize R&D costs – treat them as in intangible asset – that
helps them defer the recognition of expense on the Income Statement and instead
spread the expense over a number of years through amortization.
This inflates the company’s profits for the current year at the cost of profits in
subsequent years.
As per a report from Ambit Research, had JLR followed a similar policy of
capitalising ~33% of the R&D cost (in line with its peers) and recognising the
remaining 67% of R&D cost as an expense on the Income Statement, its restated
profits for the past two years is likely to have been lower by 22%.
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You should be concerned when a company depreciates its fixed assets too slowly
(thereby creating a boost to income), especially in industries that are experiencing
rapid technological advances.
Now, a more serious offense than slow depreciation is when a company changes the
depreciable life of its assets to a longer period. This often suggests that the company’s
business may be in trouble and that it feels compelled to change accounting
assumptions to camouflage the deterioration. Regardless of how management tries to
justify such changes, investors should always be wary.
Using big bath, a one-time charge – or a write-off – is taken against income in order
to reduce assets, which results in lower expenses in the future.
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The write-off removes or reduces the asset from the financial books and results in
lower net income for that year. The objective is to ‘take one big bath’ in a single year
so future years, in contrast, will show increased net income.
This technique is often employed in a year when sales are down from other external
factors and the company would report a loss in any event.
For example, inventory (finished goods not sold at the end of the year) valued on the
books at Rs 100 per item is written down to Rs 50 per item resulting in a net loss of
Rs 50 per item in the current year.
Note there is no cash impact to this write-down. When that same inventory is sold in
later years for Rs 75 per item, the company reports an income of Rs 25 per item (Rs
75 minus Rs 50) in the future period. This process takes an inventory loss and turns
it into a ‘profit’.
Companies will often wait until a bad year to employ this ‘big bath’ technique to
‘clean up’ the balance sheet. Although the process is discouraged by auditors, it is still
used.
Case 1: One example of an Indian company using big bath accounting to show a
remarkable turnaround is that of Tata Motors.
At the time of launching ‘Indica’ in 2001-02, the company spent Rs 1,178 crore on the
launch process. However, the company treated this as a “development expenditure”
that was to be spread over a number of years instead of the years in which it was
incurred (2001-02).
It thus wrote-off the entire amount from its “Securities Premium Account” that is
shown in the Balance Sheet, and which helped it avoid showing the expense in its
Profit & Loss account.
Thanks to this, the company showed a net loss during 2001-02 of just Rs 53 crore as
compared to a loss of Rs 500 crore in the previous year (2000-01). If this
expenditure of Rs 1,178 crore was shown on the P&L Account, the net loss for 2001-
02 would have been more than double of that in 2000-01.
In a press release, the company accepted that “…the initiative will enable the Balance
Sheet to represent “better” operational results in the future years and the true
shareholder value.”
Case 2: Mahindra & Mahindra, which launched “Scorpio” in 2002-03, took hints
from what Tata Motors did and took a big bath on its own accounts, thereby showing
a remarkable performance in that year of Scorpio’s launch, in “contrast” to the
previous year.
As an investor, you must watch out for “big bath” charges during difficult
times. Perhaps there is no better time to record huge charges than when
the market is in a downturn.
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Since during these times investors are more focused on how companies will emerge
from the downturn, large charges are rarely frowned upon; indeed, they are often
seen as a positive (“it’s the darkest before the dawn” concept).
New CEOs sometimes use the big bath so they can blame the company’s poor
performance on the previous CEO and take credit for the next year’s improvements.
• Shifting normal expenses below the line – The most common way to
shift normal operating expenses below the line involves one-time write-offs of
costs that would normally appear in the operating section. For example, a
company taking a one-time charge to write off inventory or plant and
equipment would effectively shift the related expenses (i.e., cost of goods sold
or depreciation) out of the operating section into the non-operating section
and, as a result, push up operating income. Thus, watch out for companies
that constantly record “restructuring charges” in the financial statements.
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Consider a company that is growing fast and is unsure of what tomorrow holds, or
one that has benefited from a large windfall gain or a huge new contract. Investors
surely would love to see those wonderful numbers, but they also would naturally
expect management to duplicate or even ‘outperform’ them tomorrow. Meeting those
unrealistically high investor expectations may be virtually impossible, leading the
management to feel compelled to use one or a mix of following techniques to sift a
part of their current income to a future period –
Warning Checklist
To conclude this lesson, here are some points you must write down in your
investment checklist – time to take out your ‘Diary of Dumb Investor’ – as part of
the red flags to check for while analyzing a company.
These points are relevant to how companies manipulate their revenue and profits. So
you must watch out for companies that are…
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• Showing receivables that are rising faster than sales, or simply receivables
rising at a fast pace
• Showing rising receivables days – this may suggest that the revenue increase
might have been achieved by relaxing credit terms
• Showing cash flow from operations (CFO) lower than operating and/or net
profit for many years in the past – warning for premature revenue recognition
• Capitalizing high proportion of R&D expenses
• Depreciating fixed assets too slowly (thereby creating a boost to income),
especially in industries that are experiencing rapid technological advances.
• Taking big bath expenses during difficult times.
• Seeing a sharp rise in profits just after a downturn. The company may have
used big bath accounting in the previous year.
• Boosting income using one-time or unsustainable activities
• Boosting income using one-time events
• Turning proceeds from the sale of a business into a recurring revenue stream
• Shifting normal operating expenses below the line
• Routinely recording restructuring charges
• Including proceeds received from selling a subsidiary as revenue
• Creating reserves and releasing them into income in a later period
• Seeing sudden and unexplained declines in deferred revenue
• Showing unexpectedly consistent earnings during a volatile time
Overall, if you want to avoid companies that may be indulging in a few or many of
these above shenanigans, be extremely wary of…
In the second part on financial shenanigans (Lesson #30), I will cover ‘Cash Flow
Shenanigans’ and ‘Key Metrics Shenanigans’ that some companies use to
misrepresent their financial performance.
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Exercise
Take out your ‘Diary of Dumb Investor’ and jot down these points under “Red Flags
to Watch Out For” section of your investment checklist –
• Receivables rising faster than sales, or simply receivables rising at a fast pace
• Rising receivables days – this may suggest that the revenue increase might
have been achieved by relaxing credit terms
• CFO being lower than operating and/or net profit for many years in the past –
warning for premature revenue recognition
• Capitalization of high proportion of R&D expenses
• Depreciation rates charged by a company on its various assets and compare
with that of its competitor(s) to ensure that there are no big disparities
• Company depreciating its fixed assets too slowly (thereby creating a boost to
income), especially in industries that are experiencing rapid technological
advances.
• Big bath expenses during difficult times.
• Sharp rise in profits just after a downturn. The company may have used big
bath accounting in the previous year.
• Boost in income using one-time or unsustainable activities
• Boost in income using one-time events
• Company turning proceeds from the sale of a business into a recurring
revenue stream
• Shift in normal operating expenses below the line
• Company routinely recording restructuring charges
• Company including proceeds received from selling a subsidiary as revenue
• Company creating reserves and releasing them into income in a later period
• Sudden and unexplained declines in deferred revenue
• Unexpectedly consistent earnings during a volatile time
• Signs of revenue being held back by the target just before an acquisition closes
Overall, if I want to avoid companies that may be indulging in a few or many of these
above shenanigans, I must be wary of…
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Further Reading
• Financial Shenanigans ~ Howard M. Schilit
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