๐Ÿ˜•๐Ÿ˜•12 Points To Quickly Check the Quality of Accounts

R Balakrishnan
11 June 2018 Source: Moneylife.in

Of late, several auditors have refused to sign accounts or companies have been unable to declare results on time. For the first time in India, the audit profession is facing the heat of the regulators. This has long been overdue. Which brings us to the debate about the extent to which we can rely on the declared numbers and whether there is a way to figure out what is good and what is bad.

Investment decisions are based on ‘audited’ accounts provided by companies. The auditor is effectively engaged by the promoter because he dominates the voting. Every promoter wants a ‘reasonable’ auditor, while every investor wants a ‘policeman’ auditor. And auditors were never legally culpable. The Securities and Exchange Board of India (SEBI) has changed that. Kudos to them!

Many companies are switching auditors. There may be many publicly disclosed reasons, but I suspect the truth is that the existing auditors are not happy with the numbers that the promoters want to peddle. And there are generally safe-sounding reasons for change.

As an analyst, my tasks are made harder by changing regulations that have reduced financial disclosures in annual reports, making it more difficult to spot frauds. Annual reports, today, are short on facts and long on management hyperbole that covers 90% of the annual report. There are many ‘schedules’ to the accounts that have been eliminated and attaching accounts of subsidiaries is not mandatory. The Institute of Chartered Accountants of India and the regulators have played along, to reduce the disclosures in the annual reports.

Auditors can only be as good as the promoter wants them to be. We cannot expect them to go beyond some checks. For instance, if I were to buy some customised equipment for my company, there is no basis for comparison. None of the capital expenditure is capable of being certified as 100% genuine by any one. I can simply take commissions or kickbacks. We can only check the overall cost on the basis of some ballpark estimates that go around. Similarly, the auditor has no way of ascertaining if the expenses were actually incurred. And an auditor can only do so much. So, what should an investor do? Personally, I like to go a bit deeper into the financials. Some of the boxes that I tick are:

1. It is good to start with reading the “notes to the accounts”. Often, there are auditors who put in some phrases that make you wonder about the truth. Or they may point to some issues that are not in conformity with the accounting practices. If there are red flags in this section itself, it may not be worth wasting further time on that company. When there are some adverse comments, there will also be a response from the management. It is also useful to see if there are ‘changes in accounting practices’ from one year to another. Generally, it indicates an attempt to over-/under-state profits.

2. Is the total debt declining? Or is there a visible reason for debt to increase? If a business is doing well, debt should keep reducing. Debt is often a killer and, unless the company is a bank or a non-banking finance company (NBFC) why should it rise? Rising debt hides problems in cash flow. Once in a way, when there is some expansion, there could be increase in borrowings.

3. What is the composition of fixed assets? Is there an excess of vehicles, furniture & fixtures? Is too much money at stake in land & buildings? What is the extent of ‘fictitious’ assets like goodwill, etc? I generally like to rewrite the fixed assets schedule in my own way: Land & Buildings, Plant & Machinery, Furniture & Fixtures, Vehicles, etc, for a four- to five-year period side by side and see if it makes logical sense. Is there too much of any one asset or too little of any other?

4. Are there too many associates where the company does not own 100%? Often, there are companies with ‘associates’ that are part-owned by family members and these associates can be just vehicles to siphon money out of the company.

5. Is the increase in gross working capital lower than the top-line growth? If the company has to extend more credit, or carry more inventory than proportionate to growth in sales, it is not a healthy state.

6. Is the RoE (return on equity) consistent? And does it more than cover the cost of borrowing?

7. Does the company pay tax? Is the tax rate logically correct? If tax paid is too low, I would rather pass up the opportunity.

8. Is the sales number something that is readily visible? Or is it something of an opinion, like in a contracting company? If a company sells cars or bikes, one can figure out the sales. However, when sales numbers are ‘estimates’, we get into slippery territory. I generally dislike contracting companies because of this. Sales numbers and cash numbers do not align themselves to analysis. I would rather be safe than sorry.

9. Are there many ‘associate’ companies that have a cash flow connection with the parent company? This is an open door and chances of manipulation remain high.

10. What is the trend in ‘Loans and Advances’? This is a black-hole and can hide a lot of money from the shareholders.

11. Transactions with related parties. It is useful to go through this part that is disclosed in the annual report. The more complex and lengthy it is, the more I tend to ignore the company.

12. Does the company have a lot of ‘cash & bank balances’ and, simultaneously, a lot of debt? Again, a red flag which could show that a lot of ‘window-dressing’ was done at the year-end date. Of course, one hopes that after the Satyam drama, auditors actually crosscheck with the banks on the balances as shown and signed off. I would be happy to see a separate statement in bold letters signed by the auditors as part of their audit report in the accounts.

In general, the numbers should tell the story themselves. It should not call for an IQ of 240 to decipher the numbers. And, for those of you who are fond of Excel sheets and numbers, look up “Benford’s Law”. In 1938, physicist Frank Benford made an extraordinary discovery about numbers. He found that in many lists of numbers drawn from real data, the leading digit is far more likely to be a 1 than a 9. In fact, the distribution of first digits follows a logarithmic law. So the first digit is likely to be 1 about 30% of time while the number 9 appears only 5% of the time. In a couple of cases, I have found this to be a good fit. Maybe auditors would do well to run this check on every annual report they sign off.

In this era of digital technology, it still takes three to six months for the audited accounts to be published. By the time an analyst can take it up, the next year is more than halfway through. Quarterly reports are just teasers aimed at pleasing investors. Thus, it is more useful to know about the promoters. This would limit us to companies with long track records and place speculative bets on new ones. Integrity and reputation are built over time.

Good companies will, over time, display improving financial health, throw out lot of cash, pay increasing dividends, pay income taxes, reduce their debt continuously and be in the top-3 or top-4 players in their industry. These companies would be ‘known’ and are too boring. Of course, there will be hardly a ‘joy of discovery’๐Ÿ˜œ in case of such stocks. 

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