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How companies cook up profits

We  analysed the accounts of BSE 500 companies and came up with startling results. Here's what you need to know as an investor.

Rakesh Raiand twitter-logoSameer Bhardwaj | Print Edition: February 19, 2009

Sectors With Most Creative Accounting Policies
26%: Infrastructure
12%: Real Estate
10%: Banks, Fin. services
10%: Healthcare
6%: Chemicals
6%: Consumer
30%: Others
Investment bank Noble's estimates on the sectoral break-up of BSE 500 companies that fudge accounts.

After the Satyam scam, all balance sheets and quarterly figures have become suspect. Both investors and analysts are quizzing promoters aggressively to detect the real financial health of India's listed companies. But as B. Ramalinga Raju, the now-arrested promoter of Satyam, has shown, reading the financial fine print isn't elementary. You need a different avatar of Sherlock Homes, a statistical detective.

However, dear Watson, don't be disheartened. We will tell you about a few red flags to watch out for. If you spot more than three to four of them in any company's account books, the stock shouldn't be in your portfolio. This is important today because companies are more likely to 'dress up' their financials as pressure mounts on promoters to show good results.

Money Today analysed the financials of companies that comprise the BSE 500 to find out which ones had juggled their figures in the past few quarters. So, pick up the lens, dust it properly, and learn how to become a financial forensic expert.

Counting before they hatch
:
Booking revenues in advance is a common way to inflate them. Such techniques include booking revenues before the projects are completed or goods are sold to customers. So, always compare the cash flows from operating activities (CFO) with EBIDTA (earnings before interest, depreciation and tax). If the EBIDTA growth is positive, while the CFO is negative, it may imply 'fixed' sales. In Q1 of 2008-9, Sobha Developers decided to recognise revenues earlier during a project cycle. If the accounting practice had not changed, the company's profits before tax in that quarter would have been 20% lower.

Telltale Signs That Something's Wrong
Book revenues ahead of time: Deterioration in cash flows in spite of a rise in EBIDTA suggests early booking of revenues.
Shifting of expenses away from the current period: If a company's depreciation to gross block of assets changes significantly, it may be using depreciation to manage earnings.
Mismatch in quarterly (unaudited) and annual (audited) figures: The annual PAT should tally with the quarterly numbers except for minor variations or those due to demergers or other restructuring.
Loans to related parties: Ideally, not more than 1% of loans or advances should be given to related parties (unlisted group companies or subsidiaries).
Inventory writedowns: Companies attempt to get inventory off their balance sheets and book it as revenues (thereby boosting profits).
One-time changes: Capitalisation of forex losses, losses on conversion of FCCBs, etc, not being recognised.

Make expenses look like earnings:
A change in depreciation can help promoters to either reduce losses or boost profits. In Q3 2007-8, Marico charged an additional depreciation of Rs 4.06 crore in respect of earlier years, and Rs 23 lakh for the nine months ended 31 December 2007, to its P&L account. Jet Airways changed its depreciation policy from the written down value method to the straight line one. Consequently, it wrote back Rs 920 crore to the P&L account, which helped it report profits in Q2 2008-9.

Q1+Q2+Q3+Q4 is not equal to FY:
Ideally, audited annual sales and profits should be a simple addition of figures for the four quarters, except for minor variations or changes due to corporate restructuring. According to the Capitaline database, quarterly profits of nearly 200 companies did not add up to their full-year earnings in 2007-8. Of these, 71 firms showed substantial variations. In case of Orbit Corp, Ajmera Realty and Bharat Electron, the annual profits were higher by at least Rs 44 crore. "Such discrepancies happen because most quarterly results are unaudited. Investors should be wary of these companies," says P. Anil Kumar, a chartered accountant.

All within the family:
Giving loans to companies owned by directors or promoters is a tried and tested way to siphon off cash from the listed cash cow. It can alsobe a way to hike the revenues. In the case of a large real estate firm, around 40% of sales in 2007-8 were to an unlisted group company. Now, what if the privately held firm is unable to pay for its purchases? In such a scenario, the seller (listed firm) writes off the amount as 'receivables', which are never received. When the genuine sale of the properties happens after a few months or a year, the unlisted entity books the revenues and profits,and the cost is borne by the shareholders of the listed company, whichmerely shows a book entry.

"There is nothing wrong if the loans are given on terms that are applicable to third parties. But in the absence of disclosures, it is difficult to judge this," says corporate tax expert Dinesh Patra. He adds that there could be both positive and negative spin-offs of sourcing from group companies. It could result in cost savings for the listed firm. On the flip side, such transactions allow the promoters to exert considerable influence over a company's revenues and profitability.

Pretend the inventory isn't there:
The inventories of many companies have gone up in the past few quarters even as the value of the goods has fallen. "The companies holding large inventories of commodities will be particularly affected because declining prices will compel them to do mark-to-market losses," says Tim Rocks of Macquarie Research. In Q3 2008-9, inventory write-downs of $104 million drove down Vedanta Resources' EBIDTA by 98%. To avoid such losses, the promoters can simply show inventories as sales and hike profits.

Beneath the (balance) sheets:
During boom times, several companies signed up the forex derivative contracts, hoping to gain from the movement of currencies. But after the global slowdown, these derivatives have shrunk in value. So, promoters either refuse to show these losses in the P&L accounts, or disclose the exposures, but refuse to provide for it. In the case of Bharat Forge, the impact of unrealised forex losses were carried as 'Hedging Reserve', which will be finally settled when the underlying transaction arises. In Q3 2008-9, it was not reflected in its losses.

Now that you are aware of how the figures are cooked up, here's how you can avoid such stocks. "Break the BSE 500 into different buckets-top 50, the next 100, the next 100, and the remaining 250 companies-as per market cap. The manipulation increases as you approach the bottom half. Weed out these companies," advises Saurabh Mukherjea, head of Indian equities, Noble, which was one of the few global investment banks to have raised questions about Indian promoters before Raju confessed.

Methodology:  We used these parameters to detect creative accounting by BSE 500 companies: Understating depreciation: 213 companies had reduced the depreciation rates in 2007-8. Cash flow Vs EBIDTA: 168 companies had negative change in cash flows and a positive change in EBIDTA. Variation in quarterly, annual PAT: 198 companies had profit variations in 2007-8. In 71 of the cases, the difference amounted to over Rs 1 crore. We also found that 11 companies exhibited all three parameters.

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