Dissecting annual reports and fraudulent behavior
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The document discusses the analysis of annual reports to assess financial health and uncover potential risks in companies, using the case of XYZ company as an example. Key indicators of concern include discrepancies in revenue, unusually high loans and advances, and significant increases in intangible assets, leading to negative free cash flow. The conclusion emphasizes the importance of thorough examination and understanding of annual reports for making informed investment decisions.
Dissecting annual reports and fraudulent behavior
- 1. Dissecting Annual Reports & Governance Kumar Saurabh & Shantanu Shah
- 2. Agenda • The company in focus, let us say XYZ, went burst somewhere between Apr-2015 to Jan-2017 • Could we have sensed it by 2014 that there could be such risk? • Let us try to find through annual report analysis • Before we start with annual report, let us start with quick look of financial numbers to get a sense on what all we want to search in annual report though we will read each line in detail • Concluding Remarks : What to look for in annual reports Note: To keep the audience guessing, we will 1st go through only those sections of annual report where easy guessing about company is not possible until one has gone through annual reports in detail
- 3. Key Points from Quick Financial Analysis • What is working o Revenue Growth o PAT Growth o Good Liquidity Ratios like debt to equity, quick ratio etc. • What is not working o Huge PAT to CFO Mismatch o Huge CAPEX to PAT leading to very negative FCF o Highly working capital intensive o Gradual increase in receivables and increasing debtor days o Sudden increase in other expenses o Highly fluctuating expense items o Low RoE and RoCE • What needs to be understood in detail o Why high Gross Asset/Revenue Ratio without any improvement o Why regularly high CAPEX required without improvement in asset related ratios like asset turnover, return on assets – accounting and cash
- 4. Annual Report of ABC Pvt. Ltd. : 2010-11
- 5. Annual Report : 2010-11 – Balance Sheet • Why so much rise in loans and advances , to whom it has been given? • Why sudden increase in cash? • why liabilities have increased 3 times?
- 6. Annual Report : 2010-11 – P&L • Looks good
- 7. Annual Report : 2010-11 – Cash flow statement • Why so much of loans and advances. Will financial charge and interest on FD will be a part of cash flow from operations? • What is business commercial rights? who is being paid? why?
- 8. To look for these answers, let us get into details of schedules of each item Additional Questions so far… Balance Sheet: • Why so much rise in loans and advances , to whom it has been given? • Why sudden increase in cash? • why liabilities have increased 3 times? Cash flow: • Why so much of loans and advances. Will financial charge and interest on FD will be a part of cash flow from operations? • Was is business commercial rights? who is being paid? why?
- 9. Annual Report : 2010-11 – Schedules • Why company adding freehold land? 5 crore of 32 crore asset is land. Are they going to utilize it for business? • 7 crore out of 38 crore of asset is goodwill and brand • 12 Cr out of 38 Cr i.e. 33% of assets is either land or intangible like brand. Also, please remember (quick financial analysis) gross asset to revenue, return on asset, asset turnover ratios were poor
- 10. Annual Report : 2010-11 – Schedules • 2.6 crore investment into infra company. (Remember IT company getting into infrastructure, not doubting but better to ask questions) • Why cash is pledged for working capital loans, is not hard assets enough specially 7 crore of land?
- 11. Annual Report : 2010-11 – Schedules • Why such huge loan/security deposit given to directors? • Why 10 crore of interest free loan given to employees? Is it a fair transaction for shareholder?
- 12. Annual Report : 2010-11 – Schedules • Why auditor remuneration doubled? • 33% of expense is miscellaneous. Is it too high for miscellaneous?
- 13. Annual Report : 2010-11 – Related Party Transactions • What is additional lease deposit? Why it has been provided? • why KMP is being given money for fixed asset purchase and office purchase on personal name? CEO Salary
- 14. Annual Report : 2010-11 – Other Details • Taking auditor’s service during IPO and paying separately for that is it a common practice? • why company giving bank guarantee for loan to director?
- 15. Annual Report : 2010-11 – Accounting Policies Intangibles (i) Cost incurred for acquiring brands are capitalised and amortised on a straight-line basis over a period of ten years, being the estimated useful life. (ii) Goodwill arising from acquisition of business is amortised over the expected useful life, not exceeding ten years. (iii) Business Commercial Rights i.e “facilitation service rights” acquired from various Trusts/Societies are capitalized and amortised on a straight line basis over a period of thirty years, being the estimated useful life. Revenue Recognition Income from Services is recognised on rendering of services and is recognized when there are no significant uncertainties as to its measurability or collectability. In instances where fees are received during a term, revenue is recognised on a proportionate basis for the period which falls under the current reporting period and the balance is shown as advance fees received. Revenue from consultancy services is recognised on rendering of services, as evidenced from the customers’ acknowledgment of services received. In respect of non refundable consultancy services to franchisee for setting up of its operations, the receipt of service generally coincides with signing of the franchisee service agreement. Business Commercial Rights The Company has entered into an exclusive facilitation service agreement with various bodies based on which the Company has exclusive rights for a period of 30 years to provide various facilitation services to be set up by these bodies. The Company has paid one time fixed fee to the bodies towards such rights. The fee paid is recognised as an intangible asset and accordingly capitalised as ‘Business Commercial Rights’ in the financial statements. The annual income from these bodies is based on fixed fee per customer admitted /enrolled with the bodies during the tenor of the agreement and is subject to minimum guaranteed amount each year. Joint Venture agreement The Company has entered into a joint venture agreement with XXX Builders to construct YYY building. The operations have not commenced
- 16. Annual Report of ABC Pvt. Ltd. : 2011-12
- 17. Annual Report : 2011-12 – Balance Sheet • 2 consecutive years of high increase in DTL • 50% increase in other current liabilities, check details • major increase in tangible assets • so much jump in long term loans? to whom and why? are they investing in core assets? • why loan when so much current investment. from where this money came? equity or debt? • so much cash then why loan?
- 18. Annual Report : 2011-12 – Cash flow statement • For what purpose, deposits are given? • What are these investments? • Why again for loan cash placed to bank when tangible assets increased so much? Cash and cash equivalents above includes fixed deposits of ` 409,030,556 (previous year ` 270,000,001) placed with a bank against working capital loan obtained from them.
- 19. Annual Report : 2011-12 – Schedules • 24 crores out of 82 crore asset is spent on office building of KMP? Is it a common practice? Wont renting would have been a better option? • 33% of asset is intangible, 33% is office for promoter, 12% is land. Is this asset a productive asset? Also, as we have seen asset related ratios have not been impressive • Should not we look into competitive companies and try to compare these things?
- 20. Annual Report : 2011-12 – Schedules • Story continues at a larger scale • Story continues at a larger scale • Story continues at a larger scale • Followed by 25% increase in auditor remuneration
- 21. Annual Report : 2011-12 – Related Party Transactions • Rent paid gone up by 6 times • Remuneration doubled • Advances given to KMP for his office construction • Investment in Infra company continues
- 22. So, now in Summary, lets back to all the points
- 23. Key Points from Quick Financial Analysis • What is working o Revenue Growth o PAT Growth o Good Liquidity Ratios like debt to equity, quick ratio etc. • What is not working o Huge PAT to CFO Mismatch o Huge CAPEX to PAT leading to very negative FCF o Highly working capital intensive o Gradual increase in receivables and increasing debtor days o Sudden increase in other expenses o Highly fluctuating expense items o Low RoE and RoCE • What needs to be understood in detail o Why high Gross Asset/Revenue Ratio without any improvement o Why regularly high CAPEX required without improvement in asset related ratios like asset turnover, return on assets – accounting and cash
- 24. Key Points from 2 year Annual Report Analysis • High rise in loans and advances due to • Loans given to employees and KMP at 0% interest rate • Loans given to other companies (non-subsidiary) for infrastructure construction • Loans given for KMP office building • Lot of intangible assets added as business commercial rights resulting in –ve FCF • Lot of assets added in the form of freehold land and office building resulting in –ve FCF • Cash pledged for working capital loans despite of hard assets • Auditors were given incremental fee handsomely • Miscellaneous expenses were significant • Rental expenses being paid fro KMP increased 6 times • Management remuneration for some of employees doubled • What were leasehold rights and means of accounting?
- 25. How do you feel about the company?
- 26. The company went burst after few years. ????????
- 27. Try some quantitative models for probability of fraud
- 28. Predicting PROBM : Quantitative Value by Tobias E. Carlisle and Wesley R. Gray
- 29. The Company was TREEHOUSE Company operating in pre-school business had huge receivables build-ups, any genuine possibility? Why it needed to pay money to seek exclusive rights to serve?
- 30. Why the company would have been an interesting proposition?
- 31. Why company would have been attractive 1. It's a recession proof business 2. Long runway so cash flow if it eventually becomes positive it's ok. 3. Land, Office building etc. will have immense pay off eventually. This is a service not a production business so asset turnover doesn't really apply in the traditional sense. 4. Debt is very lo and hence comfortable debt to equity 5. Strong revenue and PAT growth rate 6. PE funds are invested 7. Price has fallen from 500 to 67 8. Competitive company has plans to acquire and must have done audit – merger arbitrage opportunity
- 32. Summary 1. Ignoring CFO compared to PAT 2. Ignoring piling receivables 2. Not reading the AR thoroughly and finding complex/non-ordinary financial management 3. Getting blinded by the price ("fall from 500 to 67, how much low can it go!") 4. Getting blinded by the merger arbitrage 5. Trusting zee and it's auditors ("They must've done their analysis before okaying the merger, right") 6. Not researching the sector and other cos in the sector, etc. Even though it's a zero debt company in a recession proof sector backed by PE investors, do your homework (Read AR, as highlighted points on why to invest can make us lazy giving virtual comfort )
- 33. How to Leverage Annual Report for Investment Decisions
- 34. Structure of an Annual Report • Performance Highlights • Shareholder Communication • Corporate Governance Report - Management, Board, Compensation, AGM outcomes, Dividend, CSR, Policies • Management Discussion and Analysis • Standalone Results - Summary and Detail • Consolidated Results - Summary and Details
- 35. What to Look for in an Annual Report 1. Understanding of business and company 2. Details of Bankers, Office location and addresses, approvals and certifications, auditors, credit rating - Historic, Current and changes 3. Promoters background, Board Composition and related historic changes 4. Management and board compensation structure and growth : Salary, Fees, Hike, shares, options, warrants 5. Manage Tone - bullish, bearish, over promise, under deliver, hide facts, compared to competitors 6. Financial Details and analysis - Standalone Consolidated - revenue and profitability growth, liquidity, leverage, asset, operational ratios,significant expense items, standalone to consolidated financial flow cash conversion and generation ratios, hiding numbers, accounting frauds 7. Corporate Structure - Subsidiaries, holdco etc. 8. Related Party Transactions - Quantum and Rationale 9. Accounting principles - Level of conservatism, Uniformity 10. Management Report card : Does mgmt. makes commitment and does they live upto commitments? 11.Does management highlight risks? 12.Auditor comments 13.Accounting fraud checks 14. Shareholding Structure
- 36. What to Look for in an Annual Report Signs of fraudulent/future failure companies to look for in an annual report: 0. Doubtful means of inflating revenue : % completion method, Capital lease etc. 1. Revenue vs receivables and days sales outstanding 2. Loan growth 3. PAT to CFO Ratio, FCF/Sales company vs peers 4. Other Items - Income, Expenses 5. One time Expenses 6. Intangible Assets 7. Contingent Liabilities 8. Inter party transactions 9. Re-valuation of assets 10. Change in accounting policy, revenue recognition principle, accounting principle 11. Interest to Loan Ratio : Interest Rates 12. Cash to Debt Ratio 13. Short term Investments - Where 14. Luxury expense - Other expenses, jets, cars 15. Options, warrants, rights issue, equity dilution 16. Suspension of credit rating - change of rating agency 17. Change of auditor 18. Frequent resignations of key management and board personnel 19. Tax Payments 20. Legal Cases Signs of fraudulent/future failure companies to look for in an annual report: 21. ratio change in loans and advances given to debt taken and reserves and surplus 22. Historical merger and acquisitions and related changes in financial statements 23. Dubious background of promoter 24. Capitalizing expenses - Check FCF and competitive expense accounting policy 25. Juggling cash flow items from one section to another 26. Inventory Buildup 27. revaluation of assets which is not justified 28. Too much share price talk and use of buzz words in annual report 29. Company name and nature of business change history 30. History of promoters opening companies in sectors which is flavor of season
- 37. Over the years, Charlie and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with pen than small sums with a gun. Warren Buffet, 1988 Chairman's Letter