In the first part of this series, we wrote about how companies could manipulate earnings. We continue here with examples on how companies manipulate expenses.
The Financial Shenanigans Series:
- Part 1: Manipulating Revenues
- Part 2: Manipulating Expenses
- Part 3: Those Cash Flows!
- Part 4: Key Metric Shenanigans
- Part 5: Acquisition Accounting
In this post, we look at expenses.
Expenses: Cutting them in the Statements
Ways in which companies can tweak with expenses to manipulate earnings are –
- not recording expenses,
- shifting the expenses to a later period and
- shifting in the expenses in the P&L to Balance Sheet
For instance, commodity companies see fluctuations in inventory prices. If the cost of raw materials fall down then the company takes a hit on the inventories that it has on its books. It needs to write down the inventory on the balance sheet and book a loss on the P&L. This should be ideally adjusted with the cost of goods sold, hence the gross profits and operating profits are impacted when such an event occurs. However, some companies may shift these losses below the operating profit line, hence while comparing the operating profits, we do not see the impact. It is important to check where such kind of expenses are being recorded in the P&L.
Companies resort to shifting expenses to a later period, some of the ways in which they can do so are
- Capitalizing operating expenses
- Depreciation/Amortization over longer periods of time
- Not Checking regularly for impairment of assets
When companies incur expenses, the benefit to be received is either immediately or in the future. If the benefit is received immediately – salaries, marketing and promotion expenses they should be recorded in the P&L. For benefits that the company will receive over period of time – typically acquiring assets, an asset is created on the balance sheet and expenses are spread over the life of the asset. The problem arises when normal operating expenses, those required to run the day to day operations are not expensed but put on the balance sheet as assets. The company by following this practice reduce the expenses for that period, which gives a boost to the earnings.
For instance take the case of customer acquisition costs, these should be expenses in the period in which they are incurred. However companies will spend the cash but instead of expensing them will create a deferred asset account on the balance sheet. In the course of time they will record the expense and reduce the asset account on the balance sheet. These type of assets are recorded in other current assets and it is very important to go thorough the notes to accounts to check if the company is following any such practice. Another way to check this is to look at the free cash flow, since the company is spending the cash, it has to be recorded and this appears as spending on assets in the cash flow from investing section. FCF which is the difference between the cash flow from operations and investments would be low in this case.
Some of the checks to see if companies are capitalizing expenses are
- Unwarranted improvement in profit margins with large jump in assets
- Unexpected decline in FCF with sizeable increase in cash flow from operations. One needs to check what kind of assets the company is buying. There may be a case where the company is in a genuine CAPEX spending mode, benefits of which it will reap in the future
- Increase in CAPEX when business environment is dull or there is a slowdown across
Lot of company’s resort to capitilizing the interest costs to the assets that it acquires. While this is permitted under accounting standards, it is better to be aware the extent to which the company is capitilizing its interest costs.
Recording amortization/depreciation costs slowly over longer periods of time will also boost the earnings. We should look at the depreciation schedules and see if the depreciation policy followed by the company is permitted as per the accounting standards. Another way of boosting earnings through this way is assigning higher residual value to the asset.
For instance let us assume two companies buy the same asset for Rs 1,000. Company A assigns a residual value of Rs 200 and company B Rs 300. Residual value is the expected value of the asset after its useful life, say for instance the life of the asset is 5 years. Depreciation in the case of company A will be Rs 160 ((1000-200)/5) and in case of company B Rs 140 ((1000-300)/5). Assume all costs are the same (Rs 700) and there is only change in the depreciation expenses, both these companies generate sales of Rs 1000. In the case of company A the net profits will be Rs 140 (1000-700-160) and company B will post net profits of Rs 160 (1000-700-140).
There may be instances where the inventory may turn obsolete and it is still carried on the balance sheet. Companies need to write down the inventories and book the losses on the P&L. It is advisable to check the inventory turnover ratio and inventory days for longer periods to time. In case the inventory days is constantly going up, we need to check if the company is pilling up on inventories. In other cases companies may keep fixed assets on the balance sheet even though they have lost its value, these need to be checked for impairment.
There may be instances where companies create special charges to boost earnings. For instance a company is taking up a restructuring exercise of Rs 25 Cr. It will record an expense of this on the P&L and create a reserve on the liability side of the balance sheet. Few months down the actual charges amount to Rs 20 Cr, what happens to the balance of Rs 5 Cr that was accounted for at the start of the period? The 5 Cr is reduced from expenses on the P&L and there is no liability on the books of the company. The 5 Cr reduction in expenses provides an instant boost to the earnings.
Other expenses like warranty, pension and lease also can be used to boost earnings. It is important to go through the methods in which these expenses are recorded on the P&L.
Observations from a Travel Company
We now look into a company that was recently in the news, the company defaulted on its CPs despite having cash and bank balances on its book. The company is Cox and Kings and we looked into the FY18 annual report.
The first thing we noticed was the announcement of the companies FX business division being demerged into a separate entity Cox and Kings financial services limited (CKFSL). Companies do carry out demergers in the course of their business to create shareholder value. But in this case the demerged business CKFSL will also commence business as an NBFC. The company is moving away from its core competence by entering the NBFC space.
The company has 136 subsidiaries and 12 associates, it is going to be quiet a task for one to understand and read their financial statements with so many subsidiaries and associate companies.
Below is the share holding of the company for the last three years, we have even included the shareholding for March 2019
One can observe that majority of the shareholding is by institutions and shares pledges have increased from 2017, 63% of the promoter holdings was pledged in 2018 and 2019. Anthony Burton Meyrick Good who is the chairman of the company had 60 lakh shares in 2017, he sold 34 lakh shares during the course of the year and his shareholding at the end of 2018 was 26 lakh shares.
Some of the observations of the auditors on the companies consolidated numbers are as below
The auditors haven’t audited financial statements of subsidiaries who generated revenues of Rs 3,813 Cr, the financial statements for these have been provided by the company and have been audited by other orders.
Balance Sheet
Goodwill stood at Rs 2,468 Cr, 23% of the total assets. Goodwill as we know is the recorded when the acquisition price paid is in excess of the book value of the target company. Nearly quarter of the assets of the company are in goodwill, these need to be checked for impairment, if carrying value is found be less than the actual value these have to be written down.
Trade receivables is the next biggest item on the balance sheet. It forms 21% of total assets and 39% of current assets. We also found that receivables as % sales for FY18 stood at 35% versus 25% in the previous year. Consolidated sales for FY17 and FY18 stood at Rs 7176 and 6450 Cr. In other words this means that out of the total sales of Rs 6450 Cr, 35% were on credit for which monies were to be collected. As we will find out later some of these receivables are to be received from related parties.
Company has healthy cash balance of Rs 1640 Cr at the end of FY18.
Other current assets have increased by 62% and form 14% of the total assets. Below is the breakup of the other current assets
There are some advances that have been made to related parties, however the biggest jump is seen in the others line item, increase of 84% from Rs 446 Cr to 819 Cr. There is no detailed note describing why have these increased drastically, we only know that these are towards prepaid expenses, staff advances and others.
On the other side – the equity and liabilities section, we can see that the owner’s equity has increased by 34% from Rs 3,206 Cr to Rs 4,286 Cr. Owner’s equity funds 40% of the assets. If we deep dive into how the equity capital has seen such a drastic jump, we find the below
Equity has primarily increased on the back of increase in the retained earnings account and increase in non controlling interest. If we observe the retained earnings break up above, we see that profits during the year and profit on sale of an investment – on the back of sale of shares in subsidiary, which should be a non recurring event have contributed to the increase in equity. The profits for the year have more than doubled and we will look at the P&L statement later in the post to see what has resulted in such an increase.
On the borrowings front the company had a total debt of Rs 3,906 Cr, the debt to equity ratio of the company stood at 0.91.
Other current liabilities constitute 16% of this section and comprise of the below
The major component is the income received in advance, these are monies that the company has received, however they are yet to record revenues as they haven’t rendered their services, these will be booked in the future. One point to ponder over is if the company is receiving monies in advance from its customers, why are the receivables going up? Receivables as discussed above have increased by 23% and form 35% of sales.
Profit and Loss
Revenues have decreased by 10%. The company derives revenues 4 segments – leisure, education, hybrid hotels and others. Revenues from the leisure segment form majority of the revenue – Rs 4,180 Cr versus Rs 5,114 Cr in the previous year. It is primarily this segment has lead to the degrowth in the revenues.
Cost of tours – costs that the company incurs to arrange for various tours for its customers has decreased by 19%. We will have to dig deep into why the cost of tours have fallen 2X the fall in revenues. Ideally the cost of tours should fall in line with the revenues. However this has resulted in increase of gross revenues by 10% and improvement in gross margins from 30% to 37%.
Operating profits or EBIT have increased by 58%, OPM stand at 14% versus 8% in the previous year. This is majorly on the back of decrease in other expenses from Rs 753 Cr to Rs 569 Cr. The company has recorded a FX gain of Rs 138 Cr and this has been reduced from the other expenses.
PAT of the company has increased by 110% to Rs 444 Cr, margins stood at 7% versus 3% in the previous year. The effective tax rate has decreased from 42% in FY17 to 31% in the current year. We need to adjust for these events and look at the normalised earnings of the company.
Related Party Transactions (RPT)
As we can observe from the above, sales to RPTs stand at Rs 2,334 Cr, 36% of the consolidated revenues of the company. Majority of the sales are to “Others” – which is a JV and enterprises over which key personal have significant influence. Sales to RPT have increased by a whooping 174%, from Rs 851 Cr to Rs 2,334 Cr.
Receivables from RPT stood at Rs 460 Cr, 21% of the total receivables. These have increased by 57% from Rs 293 Cr to Rs 460 Cr.
Cash Flows
We see that the cash flow from operations (CFO) in the above statement is Rs 161 Cr, however a deeper look at this should reveal that the CFO for the year is – 161 Cr and not positive. There have been inflows of Rs 118 Cr on the back of movement in other bank balances, which have helped in increase in the cash flows from investing, we do not have the exact details of this line item. The company has also made inter corporate deposits to the tune of Rs 162 Cr during the year.
After looking at the above analysis, one should have been wary of investing in the company. There are many moving parts and lot of developments – RPTs, increasing receivables, jump in margins visible in the FY18 annual report, which should have been enough for any investor to not invest in the company. However the retail shareholding has gone up in the company since the last year. Below is the retail shareholding as on 30th June, 2019 versus what it was exactly a year ago.
As on 30th June, 2019
As on 30th June, 2018
Final Thoughts
We hope that readers would benefit from the above analysis and this would enable them to look at the finer details while going through financial statements in the future. In our next post we will cover the cash flow shenanigans.
The Financial Shenanigans Series:
- Part 1: Manipulating Revenues
- Part 2: Manipulating Expenses
- Part 3: Those Cash Flows!
- Part 4: Key Metric Shenanigans
- Part 5: Acquisition Accounting
NOTE: As a disclosure some Capitalmind authors may own the above company in their stock portfolios. There is no other relationship between Capitalmind and the above company. Please do not consider this article as a recommendation, It is purely for informative purpose only.
