Ambit uneasy over deterioration of accounting quality, the most for large-cap firms
Munira Dongre 06 December 2010

Ambit Research says that over the past four years accounting quality has deteriorated, the most in large-cap companies. Higher fees paid to auditors, rising debtor days and increasing contingent liabilities point to the need for investors to be on their guard

In a recent report to its clients, Ambit Research finds that in most sectors there is a direct correlation between accounting quality, share price changes and forward P/E multiples.

Here are highlights from the report.

  • At the overall market level there is not too much of a meaningful relationship between accounting quality and share price changes. This probably explains why many investors in the Indian market tend not to have accounting quality as a 'high priority' item on their radar.
     
  • However, when split sectorally, there is a meaningful correlation between share price performance and the accounting score (except for capital goods, diversified, housing related and tourism sectors).
     
  •  Strangely, accounting performance of the 50 largest companies by market cap had the highest decline over FY07-10, with the worst decline in FY10-the share price performance seems to reflect this.
     
  •  Ambit researchers have come up with something called the CFO/EBITDA ratio which it says "deteriorated dramatically in FY08, the final year of the previous bull market. From that perspective, the healthy CFO/EBITDA ratio for FY10 is cause for cheer.
     
  • Two big red flags according to the brokerage are the debtor days increasing, suggesting weakening operating cash flows and/or more aggressive revenue recognition. The other is audit fees as a percentage of revenues have risen in FY09 and FY10.
     
  •  Three sectors with the strongest accounting are FMCG, transport equipment and telecom (surprise?)
     
  •  The three sectors with the weakest accounting are tourism, textiles and media.
     
  •  Housing-related companies (cement, EPC and realty) dominate the list of 50 weakest companies ranked by accounting quality.
     
  •  Indian arms of large foreign accounting firms-SR Batliboi, BSR, Deloitte and PriceWaterhouseCoopers (PwC)-seem to produce better accounting scores than home-grown auditors. (This is somewhat surprising since PwC were auditors to Satyam).

Ambit has included 360 companies out of the BSE 500 companies in its analysis, leaving out 62 financial companies and 78 other companies that have not been listed for more than four years. It has put the 360 companies through something it calls 'revenue recognition checks', which includes CFO/EBITDA, audit fees as a percentage of revenues, and debtor days; 'expense manipulation checks', which includes depreciation as a percentage of gross block and contingent liabilities as a percentage of net worth; and 'cash pilferage checks' which involves miscellaneous expenses as a percentage of revenues, other loans and advances as a percentage of net worth, and advances recoverable in cash/kind as a percentage of revenues.

The CFO/EBITDA ratio checks a company's ability to convert EBITDA (which Ambit believes can be relatively easily manipulated) into operating cash flow (which is more difficult to manipulate). The depreciation as a percentage of gross block detects whether the company is changing its depreciation rate to report better profitability.

The reason tourism, textiles and the media score low is weak cash conversion, high miscellaneous expenses and high advances recoverable in cash/kind as a percentage of revenues.

Ambit claims that the top 50 companies by market cap in the BSE 500 had the highest decline in average annual (accounting) score over FY07-10, with the worst decline in FY10 and that, fittingly, in FY10 these companies saw the lowest share price appreciation. However, this is relative-they did perform 127% versus 146% by the next 50 by market cap, 192% by the next 50 and so on. In a bull market, mid- and small-caps do tend to outperform large-caps.

According to the report, promoters are largely behaving themselves. "The most encouraging trend is that all three 'cash pilferage' checks point in the right direction of minority shareholders. In general it appears that promoters are gradually coming to terms with the fact that withdrawing their hand from the cash register is good for their overall wealth."

In terms of the auditors, the report brings out some interesting points. "According to a report published by the Indira Gandhi Institute of Development Research, 80 per cent of Indian companies in FY07 and FY08 gave consultancy mandates to the same firm which conducted its statutory audit." This creates the possibility of a conflict of interest. Ambit finds that "companies which pay their auditors more seem to produce lower accounting scores." But one explanation of this is that smaller listed companies, who by and large tend to have lower accounting scores than larger companies, have to pay broadly a similar audit fee in absolute terms; so expressed as a percentage of their revenues, the smaller firms end up paying more than larger firms.

Housing-related companies have a weak accounting score because of poor cash generation (CFO/EBITDA is low), expense manipulation (the fall in the depreciation rate is high and provision for doubtful debts is low) and cash pilferage (loans and advances as a percentage of revenues is high); for chemicals and petrochemicals, scores are weak due to revenue manipulation (growth in audit fees is higher than growth in revenues) and expense manipulation (the fall in the depreciation rate is high), says the report.

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author's own and may not necessarily represent those of Moneylife.) 

Comments
BEIP FORUM
1 decade ago
Ambit Research should also conduct study on Private Banks i.e. Axis Bank and their auditors Ernst & Young.

When the banks can manipulate the books of accounts with the help of their highly paid auditors, then the Corporates will also follow the same principle.

Auditors have given AAA rating to ATM Cell, for last 4 years and they could not unearth the fraud of more than 10 crores happening at various ATM Cells and the Bank has promoted all the ATM nodal cell heads every year.

Please go through the below email to see how the manipulation in accounting takes place with the barter system well in place.


---------- Forwarded message ----------
From: SANJAY PRABHU
Date: Fri, Nov 19, 2010 at 11:30 AM
Subject: Fwd: Looting Axis
To: [email protected], [email protected], [email protected], [email protected]
Cc: [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected], [email protected]



Respected Sirs / Madam,

Please go through the trail mail which is self explanatory, and it is a gross violation of code of conduct under Axis Bank staff rules 10.8, 10.13, 10.16 and also it is a violation of Institute of Chartered Accountant of India ( ICAI ) code of conduct by the statutory auditors of the Bank i.e. Ernst & Young and request you to clarify the same at the earliest or else i will be taking this issue openly in media and through social networking sites for further inquiry in to the matter and let the Board of Directors of Axis Bank address the media on this issue.

Thanking you,

Yours faithfully

Sanjay M Prabhu
Shareholder of Axis Bank




From: Axis Wellwisher
Date: Thu, 18 Nov 2010 21:28:47 -0800 (PST)
To:
Subject: Looting Axis


Branch Mangers have been punished /dismissed for the slightest hint of impropriety .
Not so much for the Seniors .
1) M.M . Agarwals son Amit was employed with Alok Industries . Check for disbursal during the period he was with Alok Industries .
2) Somnath Sengupta 's son is an engineer from a capitation college in Bandra , Mumbai . Yet E&Y hires him at an astounding salary in US .
3) The salary of the full time cook staying at the residence of Sisir Chakraborti for the last 7 years , first when Mr. Chakrabarti was staying at Powai and now on Marine Drive ,has been paid by George Mantaince Services, the service provider who provides office boys , cleaners to Branches and offices of Axis Bank .
These people loot the Bank and teach morality and good goverance to the rest of the employes .
Branch Managers have been missed for an accidental overdraft in a relatives account . On dismissal they have lost gratuity , employer's contribution to PF and the ESOPs that they had worked hard to earn .
Why should the same standard not be used for Mr Agarwal , Mr.Somnath Sengupta and Mr. Sisir Chakrabarti.

a well wisher .
Bipin
Replied to BEIP FORUM comment 1 decade ago
Check out the proof with transaction numbers of frauds happening and no action taken by the bank

http://mmb.moneycontrol.com/india/messag...
B SRINIVASAN
Replied to BEIP FORUM comment 1 decade ago
It’s a gross violation of Corporate Governance by DMD's & CFO, as they deal in Public Money and they don’t have a right to play with such money. Its similar story that of Mr. P J Thomas, Chief Vigilance Commissioner
Nagesh KiniFCA
1 decade ago
I read mr. vinod gupta's comment after I posted mine. I'd be delighted to join with his efforts to bring in better accounting quality.
vinod gupta
Replied to Nagesh KiniFCA comment 1 decade ago
dear nagesh i am based in singapore and my home phone 65-63123405 and email [email protected]. if you are really serious , then i can share my various emails including to unitech and mr kaul of uco, let me be frank, i was utterly disapoointed by media who took advantage of my work for their benefit and will not name . i am a consultant based out of singapore having retired from comcraft group in singapore and i was with them for 17 years in business dev, finance and projects, taxation.
Nagesh KiniFCA
1 decade ago
It makes a revealing reading.
It has been happening all along, only no one spoke about it.
How does Satyam fit into it? What does the study have to say on Satyam?
How is the internal control fraud at Wipro reflected in the study?
Has any credence been given to corporate governance particularly to remuneration by way of high sitting fees and commission to directors?
Have the profits been reworked for the Auditors' qualifications for over/understatement?
The study findings need to be carried forward by Moneylife to further elaborate on the concerns listed. sooner the better before the numbers for fiscal 2010-11 come out or even Q3 of the same period.
vinod gupta
1 decade ago
apart from ACCOUNTING QUALITY, the most important is the blatant violation of accounting standards and computation of eps, i will give just three examples. unitech has blatantly violated AS 23, AS 3, AS 16 WHOSE IMPACT ON CONSOLIDATED PBT till sep 10 is about 2500 crores and no one (to whom i have written , sebi/bse/nse/ministryof corporate affaires. media like AAJ TAK, MINT , MONEYLIFE )have done anything despite my giving incontrovertible written evidence along with references which would enable anyone to verify in just 30 minutes., THEOTHWER IS EPS COMPUTATION, UCO, UNITED, VIJAYA ARE NOT DEDUCTING DIVIDEND ON pncps while doing so AND hwre i have writen to the chairman of these banks but to no avail, this matter is more important than accounting quality and i hope so,eone takes a lead as all my efforts since 30 jan 2010 have gone in vain, i am willing to assist if someone is serious to take action
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