Corporate Governance & Forensic

Accounting Quant Investor

CG & FA

Qualitative

&

Quantitative

Qualitative

Chairman of Board and CEO should be different and Chairman should be independent
Number of board members - should not be crowded
Number of Independent directors and their locations
Independent directors - Really Independent ??
Number of meetings attended by Independent directors
Role of Independent directors in committee
Independent directors and Related Party transaction
Top 10 shareholders and % shares held by them
% shares hold by promoters and trading activity by promoter group
Change in Accounting policy quite often by company and violating the accounting
policies given by ICAI
Frequent change in auditors

Quantitative

Auditors Remuneration
Board members remuneration
Various assumptions used in estimating pension expense for a period
Aggressive revenue recognition policies include % change in receivables/ %
change in revenues (debtors are growing faster than Revenue)
Capex (Cash flow statement) and Capacity enhancement
Accruals Check ( Earning quality check )
Z score ( Bankruptcy test)
M Score ( Used to detect manipulation in numbers Fraud )

Aggressive revenue recognition policy

if
Growth of Debtor > growth of sales
Number of Debtor days is higher
Pre Tax CFO<EBIDTA (excluding other Income)

Watchdog An Auditor Knows everything

The auditors report is amongst the most important sections of the annual report that minority shareholders need to
watch out for. Any qualifications made by the auditor requires the utmost attention as these may imply that
somethings amiss and that the books of accounts as presented by the management do not reflect
the actual state of the companys business realities. Things that investors should be wary of include:

Auditor: An auditor change (for example, PwCs reluctance to audit the books of accounts of Arshiya International in
FY10 and the books being subsequently audited by MGB & Co).
Auditors Report: Qualifications made or issues raised by the auditor (for example, issues raised by Lanco Infras
auditors on the consolidated financial statements in FY07 and FY08).
In FY07, the auditors of Lanco Infra had raised the following issues in respect of the consolidated financial statements:
Profits were higher by `169.29mn (or 9% of consolidated profits for FY07) due to non-elimination of intra-group
transactions and unrealised profits pending clarification from ICAI.
The consolidated financial statements were presented considering M/s Lanco Kondapalli Power Private Limited (LKPPL) as
a subsidiary with effect from 1 April 2006 when in fact, LKPPL became a subsidiary of the company with effect from 15
November 2006. As a result, profits were higher by `242.94mn (or 13% of consolidated profits in FY07).
Not only did the company not meet the requirements of AS-21 on the consolidated financial statements (given that
according to AS-21 issued by the ICAI, consolidation should have been carried out from 15 November 2006, the date on
which holding subsidiary relationship came into existence), the above treatment resulted in the profits for FY07 being
higher by `412.23mn (or 22% of consolidated profits for that year).
Auditors Remuneration: Change in auditors remuneration vis--vis change in revenue (for example, change in the
auditors remuneration for Opto Circuit.

Opto Circuit (rs. Cr.)

Revenue
Auditors Remuneration % of Revenue

2013
1.89
23.99
7.87

2012
1.40
23.57
5.95

2011
1.44
15.87
9.07

2010
0.51
10.78
4.71

Related party transactions

Investors should lookout for suspicious related party transactions undertaken by listed entities. At its
simplest, the extent of related party transactions and the trend in these transactions are important; a
sudden increase can be bad news.
However, it is often trickier than this, as the instances illustrated here show. Parties would be
considered related if at any time during the financial year, one party is able to either control the other
party or can exercise significant influence over the other. Thus, related parties would include
subsidiaries, associates, joint ventures, key management personnel & their relatives, etc. Ideally,
transactions between related parties should be at arms length. An arms length transaction would
mean that both the parties seek to execute the transaction in their best
interests.
Related party transactions
During FY08, Crompton Greaves purchased co-ownership rights in an aircraft from a related party, M/s Asia
Aviation Ltd., for an amount of `562.5mn. Mr. Gautam Thapar, MD & CEO of Crompton Greaves, was also a
director of M/s Asia Aviation Ltd, a company in the business of providing air charter services.
Whilst it is arguable that the aircraft purchase was unwarranted, the fact that it had been executed with a
related party in the business of providing aircrafts on a lease basis also raises concerns regarding the
appropriateness of such a transaction, given that Crompton Greaves could have simply hired the aircraft.
This transaction was followed by the purchase of another aircraft during FY11 for `2700mn. However, no
disclosures were made by the company in its annual report for FY11 as to whether or not this was a related
party transaction. When these issues were raised by investors with the management in 2QFY12, the
management transferred the entire block of aircrafts at book value to its unlisted related parties, M/s Asia
Aviation Ltd (`411.7mn) and M/s Avantha Holdings Ltd (`2,405mn). This last point can be detected from the
FY12 annual report.

Capitalizing Revenue Expenditure

By capitalising the R&D costs, companies can defer the recognition of expense on the P&L. This would
inflate the firms bottom-line for the current year at the cost of profits in subsequent years.
Jaguar Land Rover (JLR) seems to have consistently followed an aggressive approach towards
accounting for R&D costs. Whilst the proportion of total R&D expenses capitalised by its peer group
(Volkswagen, BMW and Mercedes Benz) over the past three years was at 25-35%, JLR has been
capitalising R&D expenses of 80-90%. This has boosted JLRs earnings. Had JLR followed a similar policy
of capitalising ~33% of the R&D cost (in line with its peers) and recognising the remaining 67% of R&D
cost as an expense on the P&L, its restated profits for the past two years is likely to have been lower by
22% (as shown in the tables below).

Accrual Check -Earning Quality

Would I want a company with Rs. 100 Net Income all paid in cash or would I want a company with Rs.
100 Net Income 90% in Debtors and 10% in cash. Since, cash is king I want the first case because I get
my money now and dont have to rely on the firms A/R collection abilities and the same money will be
reinvested into business for future growth.

So NI less a higher CFO is a good thing, you want as low a CF Accrual Ratio as possible. We also
Subtract CFI from NI too, because it is purely cash based and contains no accruals.
What we end up with is a NI that is stripped of all cash basis and contains only accruals (which are
usually bad).
So a NI- CFO-CFI trending higher is bad thing and NI-CFO-CFI trending downward is typically a good
thing and shows strong earnings quality.
So Cash Flow accrual (CFA) = Net Income CFO- CFI
CF Accrual Ratio = CFA *100/ Average Capital Employed
Capital Employed / NOA = Total Equity + All debt ( long term and Short term and other int. bearing
debt)- cash
BS Accrual Ratio = (CE (CY) CE(PY)) / Average Capital employed

Accrual Ratio

Accruals .

One More.

NOA / CE
aggregate accruals
Avg. NOA/CE
bs accruals
NI
CFO
CFI
Cash Flow Accrual
CF Accrual Ratio

FY 2013
135101.9
31688.1
119257.85
27%
29830.6
35785.60
-28946.9
22991.90
19%

FY 2012
103413.8
22795.7
92015.95
25%
26566.9
23713.20
-10281.2
13134.90
14%

FY 2011 FY 2010 FY 2009 FY 2008 FY 2007

80618.1
59487 49300.9 39882.9 25357.9
21131.1 10186.1
9418
14525
5794.9
70052.55 54393.95 44591.9 32620.4 22460.45
30%
19%
21%
45%
26%
18160.6 13510.8 18118.8
14869
7842.7
24004.60 9333.70 22505.60 6120.20 3146.50
-20516.6
-3721.3 -18665.5
-7219.2
-139.7
14672.60 7898.40 14278.70 15968.00 4835.90
21%
15%
32%
49%
22%

Altman Z Score Bankruptcy Test

M Score - Analysis ratios for detecting financial statement fraud 70% Success Ratio
Messod Daniel Beneish, Ph.D., Indiana University accounting professor, has devised analysis
ratios for identifying possible financial statement frauds. (> -2.22 high probability of Fraud)

M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI +

8 variable equation .115 DEPI -.172 SGAI + 4.679 Accrual to TA - .327
Leverage

Thank you