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Annual reports: 5 red flags to watch out for

September 14, 2017 08:30 IST

Reading companies' annual reports? Watch out for these 5 red flags

Companies' annual reports can hide as much as they reveal.
Investors can get early warning signals of wrongdoing by frequently speaking to other stakeholders, reports Sanjay Kumar Singh.
Illustration: Uttam Ghosh/Rediff.com

Recently, the Securities and Exchange Board of India announced that it would henceforth carry out a selective review of annual reports of companies for disclosure-related lapses.

Experts see this as a positive step, which will put an added pressure on companies to disclose all significant information to shareholders.

 

While Sebi does its bit, fundamental investors who typically invest in a stock for the long term need to be aware of the shenanigans companies indulge in, such as not revealing material information, burying such data deep where it is difficult to find (say, in the notes to accounts), indulging in financial jugglery, and so on.

Only if an investor can detect issues early can he quit an investment in time before he incurs losses.

1. Related-party transactions

A major disclosure-related issue lies around related-party transactions.

A promoter or a key director of the listed company may have a financial interest or may be a director in another company.

Sometimes the spouse may have a financial interest in another company. Such relationships are often not disclosed in the annual report.

Experts say there are a few signs that an alert investor can spot.

"Look at the business profile of the company's customers and suppliers.
Is the company's business concentrated around just a few entities?
What is the history of those entities? Have they been in business for long?
Do they have other customers?
If the supplier has only one customer, that should raise a red flag," says Vikram Babbar, partner, fraud investigation and dispute services, EY India.

Such information can be obtained by making enquiries with those involved in the same business.

2. Negative events

Companies that have been the subject of income-tax raids also often don't reveal such negative news in their annual reports.

These raids can sometimes be in the normal course of business.

But, sometimes they also get triggered due to company-specific issues -- either there was a whistle-blower's complaint or suspicion of tax evasion.

Such information is crucial for investors.

Experts advise that investors should carry out periodic searches on the Web in the name of the company and its promoters.

There is a high possibility that such searches may throw up any negative news about the company.

3. Revaluation of assets

Another trend that forensic auditing experts have noticed in recent times is revaluation of assets.

Companies do this to show that they are profitable when they are, in fact, loss-making entities.

They get a couple of third parties to revalue their assets, such as land and building.

They then show the market value (which is higher), instead of the book value in their books.

Such a revaluation exercise creates a reserve in their profit and loss statement, which then shows up on the profit side.

The company is, thus, able to project itself as profitable.

"Check whether the profits are on account of revaluation or whether the company has actual cash profits," says Babbar.

He adds that if a company undertakes revaluation close to the year-end, and without offering a logical explanation, that should raise a red flag.

Another financial shenanigan that is common is to report high profitability for many years, even though there are no actual cash flows.

Suppose that a company shows Rs 20 crore each year, which it adds to the reserve and surplus.

After five years it will have Rs 100 crore, which doesn't actually exist.

Then one day a Rs 100 crore is written off from the balance sheet.

"This should ideally be routed through the profit and loss account, where a loss should be shown but you may not find this information there. The balance sheet contracts, so with the same level of profit, the return on equity (RoE) looks better next year," says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a Sebi-registered independent equity research firm.

4. Layering

Promoters often try to project a rosy picture in the books of the main company, while the problems lie hidden in the books of subsidiary companies.

"To arrive at the true picture, investors need to look at the financial statements of subsidiary companies," says Shriram Subramanian, managing director, InGovern, a proxy advisory firm.

Adds Khemani: "If there are too many entities with a multi-layered structure and cross-holding, it is generally a red flag."

The exception is if the nature of the business (subsidiary in a joint venture or a foreign collaboration) or geographic expansion makes it essential to float a subsidiary.

5. High profit, no tax payout

There are companies that consistently report high profits but pay low tax.

If tax cash outflow is below the standard rate of 33 per cent, one should dig deeper to find out the reasons for lower tax.

Sometimes there are legitimate reasons like accumulated tax losses, products exempt from taxation like agricultural goods, deferred taxes, etc.

But, sometimes it could also be the case that these companies don't have real profits.

Practices that should raise a red flag

  • Frequent changes in accounting policies on depreciation or inventory,
  • Aggressive recognition of revenue.
  • Pumping up sales by pushing inventory out to channel partners and recognising it as sale, when sale hasn't taken place, also called channel stuffing.
  • High profits but low tax or dividend payout
  • Corporate guarantees given by a company to related parties, often owned by the promoter, which could turn into a liability.
Sanjay Kumar Singh
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