Accountancy Shenanigans - Case Study of a Real Estate Company in India

Accountancy Shenanigans - Case Study of a Real Estate Company in India

Published on 20 August 2021
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Accountancy Shenanigans:

Case Study of a Real Estate Company in India

With the real estate sector gathering steam in the recent few months, it has become a safe momentum play for many investors. The Nifty Realty index has seen an increase of 80% in the last one year from 18th Aug 2020 to 18th Aug 2021 whereas the Nifty 50 has increased by only 46% at the same time. However, for the longer term, there are a lot of factors regarding which the investors need to be cautious about.

Benjamin Franklin once said, “Tricks and treachery are the practice of fools, that don't have brains enough to be honest.” Let us look at some of the accounting tricks and red flags which could provide insights about the quality of earnings and the quality of financial reporting of some of the companies through an example of a major real estate company.

1. Profits are there in the books but are they getting converted into cash flows

Whenever we analyze some of the basic ratios to make an initial assessment of a stock, like operating margin, PE ratio, net profit ratio, ROCE (return on capital employed) etc. we are making a judgement based on the accounting profits. It might not be necessary that the company is able to convert these accounting profits into real cash flows.

You could have a company that is posting impressive margins and profit figures but very little cash flow to show for it. Unless and until a company manages to get cash flow for their product or services, it cannot make fresh investments, cannot finance its working capital, and could have a host of other problems.

	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20	Mar-21	Total
EBITDA/Sales %	47%	51%	50%	34%	32%	36%
EBITDA	4,668.62	4,152.57	3,334.36	2,804.83	1,940.37	1,948.63	18,849.38
Taxes	564.23	229.27	4,323.05	277.38	2,132.67	362.28	7,888.88
EBITDA - Taxes	4,104.39	3,923.30	-988.69	2,527.45	-192.30	1,586.35	10,960.50

CFO	2,956.87	-897.85	270.32	2,043.00	325.04	1,460.19	6,157.57
CFO/ (EBITDA - Taxes)	72.04%	-22.89%	-27.34%	80.83%	-169.03%	92.05%	56.18%

(Source: Company Annual Reports)

When we compare EBITDA to operating cash flows, we can get a fair estimate of cash flow conversion of profits of the company. Operating cash flows represent the outflows and inflows of the company through the day-to-day business activities of the company.

For this particular company, if the operating profit margins are seen in isolation, then one would see that while they have come down from 51% in Mar’17, they still are above 30% consistently. However, on a cumulative basis for the last 6 years, the conversion of operating profits into cash flow from operations is only 56%. Ideally, this ratio should be between 80-120% for any year. In Mar’21, the improvement in conversion is commendable and one of the reasons why this stock has shown an uptrend in recent times. However, the concerns over cash flow in the longer term still remain.

2. Struggles with customer payments? Look closely the volatility in debtor’s days outstanding and provisions for doubtful debts

All businesses, and especially B2B businesses function on credit periods. They give certain number of days (usually 30-90 days depending on industry and reputation of the business) to their customers to make payment for good or services enjoyed by them from the company. However, some customers never pay back. Some could be bankrupt while some just refuse to pay back. This money which is no longer recoverable is known as bad debts. Over a period of time, companies understand the percentage of revenue that could potentially turn into bad debts and accounting convention requires the company to make a provision for this in the books. Now, this amount is critical because it takes a hit on the company’s profitability. So, in a year when the company is having problems to sustain its profitability, it might just not provide for bad debts. We need to be aware of such notoriety.

Particulars	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20
Provision for doubtful debts	96.32	0	0	0	169.9	247.11
Net Sales	7648.73	9925.61	8221.23	6706.79	8366.09	6082.77
Provision for doubtful debts as % of sales	1.26%	0.00%	0.00%	0.00%	2.03%	4.06%
Debtor days outstanding	75	92	107	74	46	47

(Source: Company Annual Reports)

Considering the nature of the business in real estate, certain volatility of debtor’s days is expected in normal parlance of the business. However, in the case of this company, it ranges from as low as 46 days to 107 days. In addition, there are certain years in which no provision for doubtful debts have been made in the books and then restarted again. There seems to be no consistency in provisioning for doubtful debts.

3. High level of contingent liabilities in comparison to the net worth

A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

In simple terms, it is a liability that could possibly materialize in the future for the company and could result into a payment obligation. But at this point, the obligation is not probable.

It is clear from the definition that classifying something as either a liability or a contingent liability involves the use of judgement on the part of the company’s management.

Particulars	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20
Contingent Liabilities (CL)	7,730.00	9,015.32	10,064.92	13,182.27	10,236.91
Net Worth	24,069.08	24,572.83	35,310.44	33,576.54	34,446.74
CL as % of Net Worth	32%	37%	29%	39%	30%

(Source: Company Annual Reports)

There is a certain level of inherent susceptibility to contingent liabilities in real estate industry. However, in case of this company, the contingent liabilities are around 30% of the net worth of the company. In the event that some of these contingent liabilities become probable, they could have a material impact on the profitability. The statutory auditors of the company have also mentioned this as a key audit matter in their report while also stressing on the fact that classification of contingent liability is dependent on management judgement.

4. High ratio of capital work in progress to gross block

When capitalization of a fixed asset requires some time before the asset can be put to use, the costs of the asset are parked in Capital work in progress (CWIP) in the financials of the company.

Particulars	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20
Capital Work in Progress	5,730.24	1,779.06	152.76	137.33	102.92	88.70
Gross Block	23,049.77	4,142.64	3,798.17	3,014.40	3,043.28	3,356.49
CWIP as % of Gross Block	25%	43%	4%	5%	3%	3%

(Source: Company Annual Reports)

Capital work in progress is an area in the financial statements that can be used to park expenses which should ideally be expensed out in the P&L statement but are classified under CWIP at the balance sheet date so as to avoid a hit on profitability. Since the items in CWIP are usually difficult to verify for the auditor because their capitalization is still in progress, some companies could use this as an area to boost profitability. In this particular case, the CWIP to gross block ratio was significant till Mar’16 and after which it has reduced. Since Mar’17, the CWIP balance is at lower and acceptable levels. Attention should be paid to years where there is an unsubstantiated increase.

5. High growth in audit fees compared to growth in revenue

Ideally, growth in auditor’s remuneration should be in sync with the scale of increase in business size else it indicates that the auditor’s objectivity might be compromised

Particulars	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20	Growth
Audit Fees	1.13	1.26	1.82	5.74	5.59	49.14%
Revenue	9925.61	8221.23	6706.79	8366.09	6082.77	-11.52%

(Source: Company Annual Reports)

From Mar’16, the consolidated revenue of the company has decreased by 11.52% CAGR. However, over the same time, audit fees of the company have increased by 49.14% CAGR. This is an alarming rate of increase in audit fees.

6. Management remuneration vis-à-vis revenue and PAT

While analyzing a company, we must be aware of the share of pie of the management in the profits that the company is earning and watch out for any unsubstantiated increase without much increase in revenue or profits of the company.

Particulars	Mar-16	Mar-17	Mar-18	Mar-19	Mar-20	Growth
Revenue from operations	9925.61	8221.23	6706.79	8366.09	6082.77	-12%
PAT	462.02	800.26	4292.41	368.27	-1479.21	P to L

Remuneration of KMPs	31.09	33.73	53.61	55.04	35.25	3%

(Source: Company Annual Reports)

The growth in management remuneration over the last 5 years is only 3%. However, we need to pay attention to Mar’18 and Mar’19 for sudden increase in remuneration.

In Mar’18, the company had a one-time gain of Rs. 8765 Cr on account of fair valuation of its stake in one of its subsidiaries (Also the reason why the company has a high PAT). This is a non-sustainable source of income which is not translating to cash flows. However, the compensation of management has been increased by the company despite this.

Certain other key areas of concern

Although the auditors have not issued a qualified opinion, they have mentioned about the legal cases ongoing against the company in “Emphasis of Matters” section in the audit report.
The auditors have also mentioned about certain other issues in “Key audit matters” like element of judgement involved in revenue recognition, claims and litigations against the company, assessing impairment of investments in joint ventures and associates.

Conclusion

The profitability numbers might not necessarily show the true picture regarding the performance of the company. Hence, by analyzing some of these aspects, we can get an idea of any accounting gimmicks that might have been done by the management.

Now we know, how to be the “Sherlock Holmes of Investing” and which areas to look closely in the annual reports for figuring out the accounting-related tricks!

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