how to detect manipulation in financial statements…

How to Detect Manipulation in Financial Statements…

www.TechnoFunda.co.in

By Vivek Mashrani, CFA

[email protected]

@MashraniVivek

Date: 23-June-2018


DISCLAIMER

• This presentation is solely for discussion and knowledge sharing purpose; Examples shown are not intended to harm reputation of any company

• Examples shown are for understanding concepts and should not be considered as buy/sell recommendations

• All examples of various companies are provided as personal views and shown as potential signs of concern from viewpoint of some investors, however these might be genuine accounting requirement from the company’s viewpoint

• Please do your own research and due diligence for any investment actions and/or consult an investment advisor for the same

• Author is not liable for any claims arising from use of the data provided neither there is any guarantee for accuracy of data

• The views are my own and does not represent views of my employer in any manner


Agenda

• Overview

• Income Statement Related red flags

• Balance Sheet and Cash Flow red flags

• Cash Trail

• Related Party Transactions

• Auditor qualified opinion report and implications

• Suggested reading materials

• References

Overview

Let’s understand why…!!


Importance of detecting manipulation…


Capital Protection is of utmost importance…!!

“Return of Capital” is always more important than “Return on Capital”


Is knowing business model and valuation enough..?

Source: Hindustan Times


Can we blindly trust auditors and big investors..??

Source: https://www.thehindubusinessline.com/


When in Doubt, Stay out…!!

• Our objective is to find warning signs

• Red flags which needs further attention

• Signs of potential accounting manipulation

• Be more prudent during researching

doubtful companies

• Conduct checks and triangulation around

doubtful accounting items

• If unable to find the cause behind deviation,

better to stay out


The starting point of raising eyebrows…!!

• There are frequent changes of auditor

• Relationship between management and

auditor is strained

• Attempts to influence auditors are made

• There are disputes with auditors

• Information is withheld from auditors

• Frequent resignations of auditor or CFO or

independent directors


Some recent examples…!!!

Source: Economic Times, FIRSTPOST


Three pillars of financial statements

Income Statement

Balance Sheet

Cash Flow

All the three should point to the same direction if there is no manipulation

Income Statement related red flags…

One of the easiest statement to manipulate…!!


Income statement warning signs…!!

• Revenue recognition

• Recording bogus revenue

• Inflating income using one-off items

• Shifting expenses to later period

• Hiding expenses or losses

• Playing with reserves

• Inventory management

Picture source: John Del Vecchio


Revenue recognition – Recording revenue too soon

• Accelerating revenue recognition just before quarter or year end although the goods or service is not delivered

• Revenue recognized even before final acceptance of product

• Frequent reversal of revenue is a potential sign of this tactic

• Company might have genuine revenue but recognition does not happen as per accrual principles

• Accounting standards are not always black and white, management judgement is allowed in certain circumstances


Some examples…!!

Source: Business Standard; BSE filing

Sign of caution if this happens frequently..!!

Independent director of the company resigned on 21-Feb-18

quoting personal grounds


Market reaction…!!

Stock hitting continuous lower circuits since the announcement of result…!!

Chart Source: ChartNexus.com


Changes in accounting assumption..!!

• Allowed under accounting standard to fix any issues related to assumption and gives discretion to management

• Some of the retrospective changes leads to increase in one-time profit

• Need to be careful in extrapolating such profits and giving valuation multiple on the basis of that

• For example, change in depreciation assumption can lead to lower depreciation in a particular year and hence increases the profit


Example – Univastu India Limited

This may be due to genuine reason, but cause of concern if happens frequently


Recurring ‘one-time’ charges…

• Many companies show frequent one-time charges

• While a particular charge may be indeed one-time only, the company’s habit is to take one-timers all the time.

• This is a potential red flag with respect to earnings quality

• Same way showing restructuring charges for many years after acquisition is also a red flag and sign of concern

• This could done potentially to make future results look good or hide inflated results of past

Balance Sheet and Cash Flow red flags…

In the end all three statements should talk to each other…!!


Continuous increase in receivables…!!

• Most of the investors look at Net income and EPS to arrive at valuation and don’t look beyond that

• When company is in trouble and unable to get payment from customers or in some cases creating fake bills, then there will be continuous increase in receivables

• Further understanding of business model helps to identify the red flags very quickly

• Benchmarking the receivable days with competitors / peers gives an idea about industry credit norms

This may be genuine problem or manipulation, but in any case - be cautious


Some examples…!!

Source: Times of India

Potential red flags..!!


Shilpi Cables…the death was imminent..!!

Potential red flags..!!

Source: Annual report


And these are slowly written off…!!



And your suppliers also eat advances…!!



Black hole…!!



Share price performance…

Source: ChartNexus.com


Inventory Management…

• Inventory is the second most important item to track after Revenue

• Cash is invested to buy inventory

• The longer inventory ages, the possibility that the company is misallocating cash, misjudging the market scenario and possibility of write down increases

• Days sales in inventory (DSI) is used to track this – benchmark against historical days and against the competitors

• Days sales in inventory = (Ending Inventory/COGS) * 365


Playing with Goodwill and Intangibles…

• These two can be used to inflate assets on the balance sheet

• Some companies undergo frequent acquisitions which are not good for shareholders and create goodwill on the balance sheet

• Frequent capex without incremental free cash flows is also sign of mismanagement of cash

• Acquiring related party or promoter entities at high valuation and creating goodwill on balance sheet is also common way to hide / siphon cash


Working capital management…!!

• In the operating cash flow section, there is huge contribution of working capital changes coming from net income to OCF

• Many companies manipulate working capital items to increase the free cash flow

• This is done by reducing accounting receivables, expanding accounts payable and reduction of inventory

• This can only be done temporary as it is unsustainable for long period of time


Operating cash flow is important than net income..!

• Since there are greater chances to inflate revenues and accrual based net income, but operating cash flows are slightly difficult to manipulate

• Obviously, companies can play around other investing and financing cash flow to give better OCF

• Look for Operating cash flow margin i.e. OCF divided by Revenue

• It reflects business strength better than earnings. If this starts going down then it is area of concern and should checked if its temporary or persistent

Cash is KING…

Watching the trail of cash gives lot of evidence…!!


Cash is king…!!

• Check for cash yield - yield earned on cash, investments and deposits

• Investment income as a % of cash and marketable investments

• Implication of very low ratio vs. it’s peers:

a) Cash on balance sheet has probably been misstated

OR

b) Cash is not being used properly in the best interest of the company

Logic: Risk-free rate in India being ~7-8%, the cash yield from cash and investments is expected to be around 5-6%


Case Study: Low cash yield raises concerns…!!

• Cash yield for Arshiya International was ~0.4% in FY 2012 vs. peers range of 6-7%

• Calculated as: Investment income as a % of cash and marketable investments

• Even if cash is for real, it surely raises concerns on capital allocation of the company

• Later reports on increase in pledging gives signs of troubled times for the company at the best


Increase in pledged shares by promoters…!!

June 2012 shareholding

September 2012 shareholding

Source: BSE website


Concerns from employees and dividend stopped..!!

Source: BSE website; Economic Times


Finding evidence of CASH (1/2)

The money that comes out of books and taxes is real money…!!

Statutory taxes; Dividends; Buybacks – Shows at least CASH is there..!!


Finding evidence of CASH (2/2)

Company showing cash generation and accumulating it on balance sheet

Not deploying much of fund for capex or there is no capex opportunity

Not giving any dividend or not doing any buyback

Potential red flag…possibility that cash is not there or numbers are fudged


Example – Vakrangee cancels dividend plan

Source: http://www.vakrangee.in/chairmans-speak.php; ETMarkets.com


But promoters are smart sometimes..!!

Promoter knows what investors are looking for…dividend...!!

Promoter pledging their shares OR debt increasing with not much capex

Giving dividend from the proceeds…

Not a good sign…it means profits are probably not genuine…why do they raise money if they are earning??


Example - Granules India….areas of concern

Source: Company annual report; BSE website

Promoter stake going down + equity dilution through warrants + increase in borrowing to pay dividend +

high promoter salary


Potential way to siphon cash and bypass dividend..!

• Sometimes companies are genuinely producing free cash flow…

• BUT they don’t want to share the wealth with minority shareholders…

• Doing un-necessary capex frequently and inflating numbers…this is potential way to siphon cash…beware of such companies…!!

• Check for capex with peers and asset turnover ratios…!!


Curious case of Rolta India (2/2)

Source: Glaucus Research; Report published in April 2015


Curious case of Rolta India (2/2)

Source: Glaucus Research; Report published in April 2015

Benchmarking with peers is one of the way to see credibility of capex


Statutory taxes shows real picture…

• Company can cook all the items but tax payment is REAL…

• This means that in order to continue paying this taxes and hide the manipulation the company needs money...otherwise people come to know…

1) Irregularities in paying tax,

2) Deferred taxes and minimal current taxes,

3) Frequent equity dilution (to keep generating funds)

….these are some of the signs of potential manipulation or real business problem within the company…!!


Always look for contingent liabilities…!!

Source: Shilpi Cable Annual Report

High proportion of contingent liabilities to net worth indicates extremely high off-balance-sheet risk


Check for frequent equity dilution…!!

• Good companies generating free cash flow rarely need to do fund raising through equity

• Typically, equity capital is used to sustain Ponzi schemes (mainly to pay taxes, dividends or siphon funds through capex)

• Check for improvement in operating performance happening just before new equity funding… It potentially means to be done to attract equity capital and increase valuation….


Several rounds of fundraising raises concerns…

Source: Financial Express

Raised INR 400 crores though IPO in July-2015


Excellent results followed by QIP…!!

Source: Business Standard

Excellent results before QIP fund raising

Raised INR 500 Crores through QIP at almost double the IPO price


Raises further concerns for shareholders..!!

Source: Economic Times


Frequent acquisitions…generally not good..

• Cash used for acquiring companies appears in the cash from investing section

• It’s as such easy to analyze the acquisition separately, but these companies can manipulate free cash flow when they acquire inventories

• When a company makes an acquisition, it’s an investing cash outflow, but the liquidation of acquired inventory and collection of receivables are operating cash inflows. These are one-off events, but companies with frequent acquisition can keep this up repeatedly

• When this cycle of acquisition stops, actual normalized operating cash flow is visible—and it’s generally painfully less; Remember – Free Cash Flow is thus always most important to watch

• Enron used this method (out of many other ways) to manipulate OCF…!!

Related Party Transactions…!!

Devil is in the detail…!!


Related party transactions…!!

• Related party transactions done at arm’s length with genuine needs as vendor, supplier or consumer are OK

• Generally these should be very small percentage of overall revenue

• Higher proportion of transactions with related party are generally raises concerns…particularly if both entities have similar business as well as customers…BE SKEPTICAL in such cases…

• Chances of booking revenues and expenses interchangeably also increases

• Loans and advances to related parties at favourable conditions are red flags…particularly if financial condition of company lending money is not good


Even auditors are clueless in some cases…!!

Source: BloombergQuint


More examples…

Even in the middle of Cashflow trouble, companies gave loans to related parties

Shilpi Cables

Everest Kanto Cylinders

Auditor qualified opinion report…!!

Always read the fine print…!!


Auditor’s opinion report…

• The report along with financial statement from Auditor covers many comments about the company during the audit process

• This brings out approach of management and any potential areas of concern in relation to the company

• One must ensure to read this report with as much detail as possible…


Some examples…!!

Source: BSE Filing; Annual Report


Continued…

Source: BSE Filing; Annual Report


More examples…Everest Kanto Cylinders…!!

Source: Company press release

More disclosures and transparency expected from company on such matters


Summary of key items to watch for…

• Inflated revenue using receivables is most common way to manipulate

• Cash trail - amount of taxes, dividend paid, buybacks etc.

• Look for how capex is funded….be skeptical of frequent capex without much increase in FCF or with low return on capital

• Frequent acquisitions and high proportion of related party transactions

• Frequent equity dilution and audit reports; Always read notes

• Look for Free Cash Flow generation over long period of time


Some suggested further readings and references…


Few more references…

• ChartNexus.com

• BSE website

• Company Websites

• Economic Times website

• Business Standard

• Financial Express

• Glaucus Research Reports

• Ambit Research Reports


Gratitude…..

THANK YOU….!!

Always be humble…!!

how to detect manipulation in financial statements…

Documents