Business to accounting
It’s the business which drives accounting not the other way round. So when we start with an annual report I felt lot of times building of a business story in mind in tandem with financials disclosed in accounts/AR. For example, once I saw purchase of trading goods is a big number in financials, but when I red the business and look at peers I wasn’t sure why this fellow is indulged in trading. It turns out to be jacking a big number of revenue to catch some eye brows, off setting the massive losses that has resulted from key revenue streams with trading of goods (with 60% plus related party transactions).
The inverse thinking or reverse engineering is once you develop a business understanding build an accounting framework. It’s bit tiring for non accountants, but easily doable. I would like to highlight few old posts which talked about meaning and definition of financials including key accounts and disclosures, principles etc.
Example and disclosure remains same, Maithan Alloys.
First the “seedhi” soch (straight thinking):
- Maithan needs raw material to produce alloys.
- Requires plant & machinery, land/building for production facilitation.
- The key ingredients other than raw material for production, quality check i.e. power, labour.
- A logistics system to deliver the alloys to customers.
- Corporate office for book keeping, HR, strategy and all other corporate function.
- Sales and marketing office to manage direct marketing if any.
If you see strategy canvas earlier we discussed, absolutely in line with key attributes. If you see the competitive landscape you will realise some competitors are doing differently. Their accounts will not be same as Maithan Alloys like trading in raw material (a big chunk of trading profit/loss you will find along with operational revenue). Now I leave a question for you on peer comparison.
Second the tedhi such or reverse thinking:
- what was the preliminary expenses that were written off to build the plants (difficult to get old ones, new plants like Maithan’s vizag should be easy.
- heavy hand of management, what is the opportunity cost foregone to build the business.
- advertisement and marketing expenses spend over the years which yielded results or non results (not expecting much being an intermediate products).
- was one time benefit like tax, fixed asset subsidy heavily build into business making? this would have developed a biased financials with incentive.
- few others like quality defect etc difficult to get, I am ignoring.
Third and last yeda such (orthodox thinking):
- How company is funding fixed assets and working capital?
- what are trade off available against key drivers (say for power buy vs own and generate)
- how I am managing margins short fall if any (absence of pricing power)? (say paid through additional capital?)
- are my asset maintenance heavy?
- have I ventured out like acquisitions and subsequently written off a great deal of money? This is actually positive, it could have impacted badly but management wont repeat again!
- am I subjected to high skilled employee requirement and why?
As I mentioned in my post, don’t worry about completeness. When you build prototype (meaning all dynamics infused and again challenged) likely gaps should come out before final product.
Now think about financials of Maithan Alloys:
Enforced activities (no choice, must to do):
- Raw material, power, labour, sales, logistics accounting.
- Asset funding, working capital funding accounting.
- Support/corporate expenses to the reasonable extent.
Voluntary activities (optional):
- Trade off decisions
- Business restructuring decisions (amalgamation, consolidation etc)
- One time decisions (discontinue product/operations)
Possibility of non disclosure:
- Expenses written off on various accounts (advt, preliminary expenses, R&D, promotion etc)
- Unsuccessful business restructured
- All wrong one time decisions
- Convention other than historical cost and other accounting practice (like land at cost value, decision not to write off inventory/debtors). This is what we need to hunt from creative accounting practices.
Non disclosure of information is the most difficult part to achieve. Don’t blow your head off for accuracy and completeness. An intellectual estimation or guess is all required than absence of estimation.
Can you spot some of the impact of these things:
- All the ratios you are calculating can be terribly wrong. For example inventory turnover where 25% of raw materials are obsolete and disclosed but not taken to financials. We must identify and adjust these big ticket numbers and that’s why I said earlier the objective is to find “adjustments required to financials”.
- Either over stated or under stated book value (land bought in 1967 never revalued) leading to gross mistakes in reproduction value of assets.
- Serious errors committed by management like failed business restructuring (I would like to see if it’s a hired hand he should be asked to march out).
- Auditor’s reluctant disclosures. Auditors are always caught between integrity and profit, they don’t want to upset client ; at the same time can’t compromise on certain auditing standards. Most of them they choose a middle path i.e. disclosures and note to accounts. These two unearth wealth of information.
Fair, lets get back to our work.
Now we know what Maithan’s account should have, lets get into 2015-2016 annual report and peep into it.
Maithan Alloys Balance Sheet and Profit & Loss
Share capital and reserves: nothing usual, a bonus issued in 2015. Long term borrowings: a foreign currency loan on mortgage of Vizag plant for the sam plant ( I guess cheaper cost of capital). Deferred tax liability (accounting treatment of taxes due to tax books and financial books).
Long term provision- employee benefit for gratuity. Short term borrowings - a working capital loan against hypothecation of goods, plant and other fixed assets (combination of rupee and foreign currency loan). Accounts payable- business as usual.
Other current liabilities- maturities of long term loan (why?) and others payables of 103 Cr (not known). Short term provisions- again employee benefit (may be bonus).
Fixed asset- a lots of tangible (land, building, plant, vehicle etc), intangible includes software and good will (indicating an acquisition of company). Point to note, these good will again are accounting treatment, seldom have no reproduction value.
Long term loans and advances include deposits , Current investments- mutual fund investments
Inventories- again big raw materials, spare parts etc.
Trade receivables, Cash and bank balances, short term loans , other current assets, revenue (only sale of products), employee benefit, power cost, finance cost, depreciation, other expenses (big ones include stores, repairs, freight, export expenses).
At first look nothing unusual to business but as they devil is hiding in fine details. The reverse thinking and orthodox thinking is a combination of business performance and creative accounting practices to unearth. Creative accounting practices, lets tackle it separately. I will rather focus on visible things for now, key points for consideration:
1. Bonus issued in 2015 (capital allocation decision)
2. Amalgamation somewhere and good will account
3. Foreign currency loan to minimise cost of capital?
4. Probe further on break up of other payables and classification of long term maturity within current liabilities.
That’s a very short and sweet list to start with. The possible financial adjustments will come by reading notes, directors/auditors report, and accounting policies. Lets cover that off in creative accounting practices.
For now, I will jump to Risk side.
Risk Profile of Company
Well these are business risks emanating from decisions taken on area of financial reporting, strategy, compliance to rules and regulations and operations of business. This has nothing to do with stock price risks.
A very good tool to know the risk profile is application of ERM or Enterprise wide risk management. But at same time next to impossible for a retail shareholder to do an ERM assessment sitting outside with minuscule information when company themselves are struggling to implement ERM. But an mindset towards ERM will help to have again best estimate on available information on the risk management capabilities.
Under ERM framework the objectives of company are split to 4.
- Strategic- high level goals, aligned with and supporting its mission
- Operations- effective and efficient use of resources
- Reporting- reliability of reporting
- Compliance- compliance with applicable rules and regulations
To understand whether company has fulfilled or attempted to achieve these objectives one needs to understand eight components.
- Internal environment- tone of organisation and set the basis for how risk is viewed and addressed. This include risk management philosophy, risk appetite , integrity , ethical values etc.
- Objective setting- a process in place to set objectives which support mission and risk appetite.
- Event identification- internal and external events affecting the objective must be identified. This can create either risk or an opportunity.
- Risk assessment- risks are analysed , with likelihood and impact. Assessment of both inherent and residual risk.
- Risk response- avoid, accept, reduce or share the risk.
- Control activities- policies and procedures are established to help risk response being implemented.
- Information and communication- information is identified, captured and communicate to people to carry out their responsibilities against control activities.
- Monitoring- independent guys assess the effectiveness of ERM and suggest for modification.
(For detail google COSO-ERM).
Under claus 49 of listing agreement all our companies are suppose to identify risks, quantify them, build response and identify failures, report and audit. And COSO_ERM was a suggested framework. But this never happened in true spirit, risks are disclosed as style statements and copy paste than reality.
But not everything bleak and dark. There is a limited way to crack this unusually complex framework. Of course to the extent what we require and to do that we need to know how a ERM is performed.
- The risk you see in annual reports are not some sort of casual discussions within management members and then paste it to AR.
- Every company should carry out a formal risk management plan , establish risk appetite and all other components of ERM documented. The documentation is called Risk register and controls identified against it are tested regularly for effectiveness.
- Every failure that resulted in risk register must be reported a host of people including auditors and regulators.
Now the problem is a lot of risks are subjective, regulators do not have band width for a water tight implementation. That leaves the auditor to hold the quality, I hope recent IFC will enhance the process further though a long way to go.
How do we spot key points for risk management for OUR NEED?
First it lies within the strategy value chain. Lets give it a shot for Maithan and compare what management has written in AR.
1. The biggest risk for this company is assured production backed by sales to cover it’s fixed costs. Or else within few years it will vanish. We can call at “UNUTILISED CAPACITY”.
2. Quality of product is poor. “QUALITY RISK”
3. Next is if you can not fund working capital and fixed capital for a company with high fixed cost again net worth will erode quickly. Lets call it as “CAPITAL RISK”.
4. Moving on one must stay close to customers and vendors here. “LOCATION RISK”.
5. A substantial portion of company revenue is exports, need forex risk to be managed. “CURRENCY RISK”.
6. With so many operational efficiency requirements, back up to key management members is important. “SUCCESSION PLAN”.
7. Unavailability of raw material and power can jeopardise the operations. I will call rather “INPUT AVAILABILITY RISK”.
8. Compliance to labour laws, internal controls, and tax laws. “COMPLIANCE RISK”.
From a strategic perspective substitute products, tailor made value chain we have already analysed earlier. Not repeating them.
Now lets see what management is saying:
1. Industry risk (sector volatility)- nothing but unutilised capacity
2. Quality risk (poor quality)
3. Competition risk (no entry barrier)
4. Currency risk
5. Geographic risk
6. Liquidity risk (capital risk to fund operations)
7. Compliance risk (covered generally in audit report, directors report and notes).
Pretty much on same line what we are thinking, except probably to me succession plan and input availability risk.
Have they managed to mitigate the risks, that’s part of performance management. Somewhere down the line for us to explore!
Next step is to sniff the creative accounting practices and that’s fun as well.
Good wishes and happy investing.
The highlighted ones are the only portion gone to my stock refresh document which I am doing simultaneously. half of a page.