Satyam's True

: “I am not upset that you lied to me, I am upset that from now on I can't believe you”

—Friedrich Nietzsche

The Satyam Computers imbroglio threatens investors to get into a 'whom do I trust now' mode. And this is quite likely, as the scale of the fraud will have investors, both institutional and retail, get into a shell and for some time, forsake investments in the equity markets.

But then this is as big a mistake as in the first case to trust companies blindly. It is a totally opposite reaction. Many of India's leading lights from the corporate and investing world have said that Satyam's case is a one-off case. Well, it might not be and there could be more skeletons tumbling out of India Inc's closet, the fact remains that not all companies are as devious and that many companies resort to window dressing (see overleaf for examples) and that even they might not be bad.

Window dressing or making up accounts is not a new phenomenon. Not in India and not across the globe. There are thousands of cases of window dressing and accounting frauds that have come to light and even more than have not.

The source of all this lies in corporate governance practices and investor awareness in not tolerating accounting stews. “I think that the failures of Enron and WorldCom and other companies are partially failures of investors to recognise companies that are selling for a thousand times nothing, but chances are they may be worth only that,” said Arthur Levitt longest serving chairman of Securities Exchange Commission of the US.

So, to a great extent, investor demands and blind greed have been also responsible for such frauds to perpetrate, apart from the devious promoters and entrepreneurs.

Why frauds

Cooking accounts, fudging books are not new to India. The earlier days of the existence of the licence Raj meant that the big industrial houses had to float several different companies in the same line of business to get licences. And, when this happened, there were incessant inter company transfers that would take place, often gypping publicly listed companies. The structure at that time prompted such malpractices.

However, better times and global access to funds meant that the companies had to shore up accounts and follow international disclosure norms. Many companies improved their acts. But then tough times call for tough actions, and the pressure to maintain quarter on quarter earnings growth meant that the companies had to resort to nefarious means. And many did.

“We need to keep in mind that history has shown that boom/bust cycles tend to throw up such governance failures in various countries - Enron, Vivendi, Parmalat, Daewoo, Worldcom, Livedoor, etc,” says Sukumar Rajah, CIO of Franklin Templeton Asset Management in India.

And indeed this is the cyclical turn that has taken place. Apart from the accounting loopholes, W Steve Albrecht author and professor at Bringham Young University and somebody who has studied financial statement frauds over a period of time, says that there are several reasons why such frauds are done.

One of them is that there is a vibrant economy, a growing one that creates cheer amongst all participants and when the market is booming, little attention is paid to such acts. And when the promoter gets away with such things, it becomes a habit. As B Ramalinga Raju had to say in his famed letter to the regulators and exchanges, “What started off as a marginal gap between operating profit and the one reflected in the books continued to grow over the years and. It has attained unmanageable proportions as the size of the company grew significantly.”

Then there are the analysts and the traders who create this pressure for the company to present strong quarter on quarter numbers. Better consistency means lower risk in earnings and therefore a better valuation. This is a 'short-term' trap that the companies fall in their quest to get premium valuations. Scruples are often set aside.

There is also the role of the profit-linked bonuses that lure executives to take the easy way out and compromise governance practices. And then there are the corrupt auditors and professionals as well. These are the people and circumstances that lead to corporate fraud.

Spotting frauds

And for investors it is not really difficult to smell one, though cases like Satyam Computers can be a shocker as the company had won several accolades for its corporate governance. But still some telltale signs were present.

Here, one can follow Benjamin Spock, the American author's wisdom, “Trust yourself. You know more than you think you do.” There are a few ways that companies mislead investors and other, they are: Revenue or receivables fraud, inventory mismanagement, understating liabilities, overstating assets, overall misrepresentation. The balance sheet and the profit and loss accounts have enough evidence to set off a trail, though they might not tell you the exact story.

Frequent changes in accounting norms, especially the manner in which inventories are valued, is the easiest one, and often legal. So is changing the method of depreciation from the straight line method to a written down value method, where there are simple accounting changes and the profit tends to look inflated (examples overleaf). Companies are obliged to report such changes and the extent to which they change the profit numbers and most of the companies do report them. They might not be called fraudulent acts but are unethical and an indication that the management is working up the numbers. Many private equity investors in India are suing companies because they had cooked up inventory numbers and prompted them to take investment decisions. Something simple that even the expert investors overlook.

Then there are the huge amounts with debtors that swell. Many revenue frauds are perpetrated through these means. Investors should take a look at the debtor numbers and the ratio of debtor days. Such ratios are readily available with several online personal finance portals for free. The point is that investors should look out for an increasing trend of debtor days or uncanny spikes in certain quarters where sales numbers have not looked so good. “Cooking up revenue numbers is the biggest cancer as it then percolates down the P&L and infects other numbers as well,” says Sailesh Shah, a chartered accountant.

Overstating assets can't really be tracked to the detail by investors but, there are companies that frequently rely on revaluing their assets. This usually happens when the company intends to raise money, especially before an initial public offer. Investors should be wary of such companies.

And then there are the promoters who have several companies in the same line of business, not really bothered about the age old maxim of getting economies of scale. A listed company would then often make loans to its group company at concessional rates or receive loans at exorbitant rates. And in such cases there are inter-group sales and transfers that are affected at beneficial rates.

These are all the shenanigans that several unscrupulous managements have been using to deceive the public, little knowing the damage they could create. “Financial statement fraud causes a decrease in market value of stock of approximately 500 to 1,000 times the amount of the fraud,” says Albrecht. Often, this damage is inflicted on the investing community. In the case of Satyam, the Rs 7,400-crore scam and mismanagement has seen Rs 18,000 crore of wealth being wiped off till now.

More importantly, the first important and oldest investment lesson is that the biggest risk in an investment is the promoter or management itself. Sound managements have known to make weak projects work and generate wealth and bad managers have caused most exciting projects to collapse.

As for investors, the best advice is the one that the sage of Omaha would give, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” It is time that investors shun companies that chronically resort to window dressing. This is probably the lesson of the new year.

Source: FE Investor Bureau

What is recession?

This Story is about a man who once upon a time was selling Hotdogs by the roadside.
He was illiterate, so he never read newspapers. He was hard of hearing, so he never listened to the radio.
His eyes were weak, so he never watched television. But enthusiastically, he sold lots of hotdogs.

He was smart enough to offer some attractive schemes to increase his sales. His sales and profit went up.

He ordered more a more raw material and buns and use to sale more. He recruited few more supporting staff to serve more customers.
He started offering home deliveries. Eventually he got himself a bigger and better stove.

As his business was growing, the son, who had recently graduated from College, joined his father.

Then something strange happened.

The son asked, "Dad, aren't you aware of the great recession that is coming our way?" The father replied, "No, but tell me about it." The son said, "The international situation is terrible. The domestic situation is even worse. We should be prepared for the coming bad times."

The man thought that since his son had been to college, read the papers, listened to the radio and watched TV. He ought to know and his advice should not be taken lightly. So the next day onwards, the father cut down the his raw material order and buns, took down the colourful signboard, removed all the special schemes he was offering to the customers and was no longer as enthusiastic.

He reduced his staff strength by giving layoffs. Very soon, fewer and fewer people bothered to stop at his hotdog stand. And his sales started coming down rapidly, same is the profit.

The father said to his son, "Son, you were right". "We are in the middle of a recession and crisis. I am glad you warned me ahead of time."

Moral of The Story: Its all in your MIND! And we actually FUEL this recession much more than we think.