Ambit uneasy over deterioration of accounting quality, the most for large-cap firms   

December 6, 2010

Ambit Research says that over the past four years accounting quality has deteriorated the most for large-cap companies. Higher fees paid to auditors, rising debtor days and increasing contingent liabilities point to the need for investors to be on their guard

In a recent report to its clients, Ambit Research finds that in most sectors there is a direct correlation between accounting quality, share price changes and forward P/E multiples.

Here are highlights from the report.
•    At the overall market level there is not too much of a meaningful relationship between accounting quality and share price changes. This probably explains why many investors in the Indian market tend not to have accounting quality as a ‘high priority’ item on their radar.
•    However, when split sectorally, there is a meaningful correlation between share price performance and the accounting score (except for capital goods, diversified, housing related and tourism sectors).
•    Strangely, accounting performance of the 50 largest companies by market cap had the highest decline over FY07-10, with the worst decline in FY10—the share price performance seems to reflect this.
•    Ambit researchers have come up with something called the CFO/EBITDA ratio which it says “deteriorated dramatically in FY08, the final year of the previous bull market. From that perspective, the healthy CFO/EBITDA ratio for FY10 is cause for cheer.
•    Two big red flags according to the brokerage are the debtor days increasing, suggesting weakening operating cash flows and/or more aggressive revenue recognition. The other is audit fees as a percentage of revenues have risen in FY09 and FY10.
•    Three sectors with the strongest accounting are FMCG, transport equipment and telecom (surprise?)
•    The three sectors with the weakest accounting are tourism, textiles and media.
•    Housing-related companies (cement, EPC and realty) dominate the list of 50 weakest companies ranked by accounting quality.
•    Indian arms of large foreign accounting firms–SR Batliboi, BSR, Deloitte and PriceWaterhouseCoopers (PwC)–seem to produce better accounting scores than home-grown auditors. (This is somewhat surprising since PwC were auditors to Satyam).

Ambit has included 360 companies out of the BSE 500 companies in its analysis, leaving out 62 financial companies and 78 other companies that have not been listed for more than four years. It has put the 360 companies through something it calls ‘revenue recognition checks’, which includes CFO/EBITDA, audit fees as a percentage of revenues, and debtor days; ‘expense manipulation checks’, which includes depreciation as a percentage of gross block and contingent liabilities as a percentage of net worth; and ‘cash pilferage checks’ which involves miscellaneous expenses as a percentage of revenues, other loans and advances as a percentage of net worth, and advances recoverable in cash/kind as a percentage of revenues.

The CFO/EBITDA ratio checks a company’s ability to convert EBITDA (which Ambit believes can be relatively easily manipulated) into operating cash flow (which is more difficult to manipulate). The depreciation as a percentage of gross block detects whether the company is changing its depreciation rate to report better profitability.
The reason tourism, textiles and the media score low is weak cash conversion, high miscellaneous expenses and high advances recoverable in cash/kind as a percentage of revenues.

Ambit claims that the top 50 companies by market cap in the BSE 500 had the highest decline in average annual (accounting) score over FY07-10, with the worst decline in FY10 and that, fittingly, in FY10 these companies saw the lowest share price appreciation. However, this is relative–they did perform 127% versus 146% by the next 50 by market cap, 192% by the next 50 and so on. In a bull market, mid- and small-caps do tend to outperform large-caps.

According to the report, promoters are largely behaving themselves. “The most encouraging trend is that all three ‘cash pilferage’ checks point in the right direction of minority shareholders. In general it appears that promoters are gradually coming to terms with the fact that withdrawing their hand from the cash register is good for their overall wealth.”

In terms of the auditors, the report brings out some interesting points. “According to a report published by the Indira Gandhi Institute of Development Research, 80 per cent of Indian companies in FY07 and FY08 gave consultancy mandates to the same firm which conducted its statutory audit.” This creates the possibility of a conflict of interest. Ambit finds that “companies which pay their auditors more seem to produce lower accounting scores.” But one explanation of this is that smaller listed companies, who by and large tend to have lower accounting scores than larger companies, have to pay broadly a similar audit fee in absolute terms; so expressed as a percentage of their revenues, the smaller firms end up paying more than larger firms.

Housing-related companies have a weak accounting score because of poor cash generation (CFO/EBITDA is low), expense manipulation (the fall in the depreciation rate is high and provision for doubtful debts is low) and cash pilferage (loans and advances as a percentage of revenues is high); for chemicals and petrochemicals, scores are weak due to revenue manipulation (growth in audit fees is higher than growth in revenues) and expense manipulation (the fall in the depreciation rate is high), says the report.

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author’s own and may not necessarily represent those of Moneylife.)  — Munira Dongre